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Frederick Willhemm Pig lives in the Republic of Warthog. He works as a water engineer in...

Frederick Willhemm Pig lives in the Republic of Warthog. He works as a water engineer in the Warthog Ministry of Water & Natural Resources. To prepare for his retirement, Mr. Willhemm invests heavily in corporate and municipal bonds. Recently, he discovered that when interest rates rise, bond prices fall. Can you explain to Mr. Willhemm why this is so?

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Bond prices represent net present value (NPV) of the cash flow stream the bonds will generate over their lifetime. NPV is dependent upon two factors: Cash flows, and rate of discount. In case of bonds, the cash flows from them are fixed (a combination of coupon and redemption values), but the discount rate is determined by the market rate of interest. As the market rate of interest goes up (it represents the opportunity cost of investing in bonds), NPV will go down since the rate of discount on the cash flows produced by the bonds will increase, resulting in NPV going down. Hence the price of bonds will go down.

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