jmherbenerBonds issued in the past have stipulated interest payments that do not change over the life of the bond. For example, suppose a twenty year bond issued in 2000 had a face value of $10,000 and paid $600 a year in interest to the holder. Then the interest return on that bond when it was issued was 6 percent. Now suppose that a twenty year bond issued today with a face value of $10,000 paid $200 in interest to the holder for an interest rate of 2 percent. Investors today would want to buy the 2000 bond and not the 2013 bond. They would bid for the 2000 bond until its price rose to approximately $30,000 so that the interest return on that bond was also 2 percent. If interest rates in 2016 have risen back to 6 percent, then the price of the 2000 bond will have fallen back to $10,000 (making its interest return conform to the market rate of 6 percent) and the price of the 2013 bond will have fallen to approximately $3,333 (making its interest return conform to the market rate of 6 percent).
The general principle is that the interest return on all bonds issued in the past must conform to the current interest return, which will also be the interest return on newly issued bonds. The interest return itself is determined by people’s willingness to save and invest.