Price Sensitivity and Risk

The Inverse Relationship

Bond prices and interest rates move in opposite directions. This is the fundamental risk in fixed income investing.

When Interest Rates Rise

• New bonds offer higher coupons
• Existing bonds with lower coupons become less attractive
• Existing bond prices fall

When Interest Rates Fall

• New bonds offer lower coupons
• Existing bonds with higher coupons become more attractive
• Existing bond prices rise

Why Does This Happen?

The present value of future cash flows decreases when discount rates increase. Since a bond is a series of fixed cash flows, its value is inversely related to the rate used to discount those flows.

Credit Risk

Credit risk is the risk that the issuer cannot fulfill its payment obligations. It is measured by credit ratings (AAA = highest quality, D = default). Higher credit risk means higher yield demanded by investors. German Bunds are rated AAA—considered among the safest securities globally.

The Risk-Return Spectrum