One of the most common statements in fixed income markets is that bond prices and yields move inversely. When yields rise, prices fall. When yields fall, prices rise. Many treasurers are familiar with that rule, particularly when looking at gilt markets or bond funds, and it is certainly something we often say in training courses and meetings with clients, but the reason for it is not always immediately obvious or understood.
At the simplest level, a bond is just a series of fixed future cashflows. For a conventional bond, those cashflows are the coupon payments and the repayment of principal at maturity. Once the bond has been issued, those cashflows do not change. What does change is the price investors are willing to pay for them.
A useful starting point is the income yield formula:
Income yield = annual coupon / price
If a bond pays a fixed £5 coupon and is trading at £100, the income yield is 5%. If the price falls to £95, the income yield rises to 5.26%. That helps explain the inverse relationship, but it is only part of the picture.
In practice, bond investors usually focus more on yield to maturity, also known as the gross redemption yield. This is a broader measure because it takes account of not only the coupon income, but also of any capital gain or loss between the purchase price and the amount repaid at maturity. In essence, it represents the total return of investing in the bond (albeit with some assumptions).
For example, suppose a bond has a face value of £100 and pays a 5% coupon. If it trades at £100 and is held to maturity, the investor receives £5 a year and £100 back at the end. If market yields then rise, newly issued bonds may offer a better return. The existing bond still only pays £5 a year, so its price has to fall in order to remain competitive, or to put it another way, investors are no longer willing to pay as much for it. If its price then falls to £95, the investor still receives the same £5 coupon, but now also benefits from a £5 capital gain when the bond matures at £100. The total return has improved, so the yield to maturity has risen.
The reverse is also true. If market yields fall, an existing bond with a relatively generous coupon becomes more valuable. Investors may be willing to pay more than £100 for it. In that case, they still receive the coupon, but if they hold the bond to maturity they will get only £100 back, so part of the return is offset by a capital loss. The higher price pushes the yield to maturity down.
This is the real reason bond prices and yields move inversely. The bond’s contractual cashflows are fixed, so the market adjusts the price until the bond’s overall return is in line with prevailing market rates.
This also explains why bond funds fall in value when yields rise. The underlying bonds are repriced to reflect new yield levels, even though the promised cashflows themselves have not changed. The relative sensitivity of a bond’s price to changes in yields is measured by its ‘duration’, which is shaped by factors such as maturity, coupon and yield. This is an important concept in fixed income markets, but one for separate exploration.
In practice, market yields are influenced by factors such as inflation expectations, central bank policy, economic conditions, credit quality and investor demand. When those influences change, bond prices adjust because the cashflows do not.
Arlingclose provides investment advice, including advice on accessing bond markets directly and through pooled funds. We also provide borrowing advice, macroeconomic services and training on these and other treasury management related topics. To learn more, please contact us at info@arlingclose.com
01/05/2026
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