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Bonds are initially sold to investors at a single fixed price. The price of the Bonds will then fluctuate until maturity (or default). If the general level of interest rates moves higher, for instance, the price of these bonds will decrease. This relationship should be obvious when one considers that new bonds, carrying coupons with the new higher interest rate, will certainly be more attractive to investors. The price of our original bonds would have to go down to bring their value in line with the newly issued Bonds.
The central tenet of Bond Market investing is that prices and yields move in opposite directions. Bond prices go up when Bond yields go down, and vice-versa.
Pursuant to this relationship, Bonds are often considered "counter-cyclical" securities, meaning that Bond prices tend to be high and yields tend to be low when the economy's performance is poor. This factor is probably the single most important reason for having some Bonds in your diversified portfolio.
Though there is a great deal of overlap, distinction needs to be made between factors affecting interest rates and factors affecting the price of an individual bond. Interest rates shift in response to a number of factors including: the demand and supply for credit, Federal Reserve policy (monetary policy), fiscal policy (government budgeting and expenditures), tax policy, exchange rates, general economic conditions, price inflation, perceptions and forecasts for future inflation and a host of lesser factors.
Individual Bond prices are not only affected by all of these factors, but additional ones as well. These factors include: supply and demand for the specific issue, liquidity of the issue, special characteristics of the issue, credit quality, perceptions and forecasts for changes in credit quality and a host of lesser factors.
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