Let us consider the case of zero-coupon bonds. This type of bond does not pay interest until the maturity period. The interest is computed by deducting the purchase price and the par value paid at maturity. (Investopedia, 2007a) For example, the trading price of a zero-coupon bond is at £100 and has a par value of £130 which is paid at the maturity period of 1year. The bond’s rate of return at the present time is approximately 30% ((130-100)/100 = 30%).

Generally, the satisfaction of the investor receiving a 30% return depends a lot on the overall performances in the bond market. In case a new bond that gives a 35% yield is currently offered in the market, the investor receiving a 30% return from the zero-coupon bond will not be satisfied because the main interest of bond investors is to gain a bigger return on investment (ROI). The new bond will, therefore, make the zero-coupon bond less attractive causing its demand to decline. (See diagram below)

In case the current interest rate of a zero-coupon bond increases up to a 35% yield, the said bond will be attractive and will increase its demand. In doing so, the price of the pre-existing zero-coupon bond will decrease up to such point that it matches the same return yielded by the prevailing interest rates. In this case, the price of the bond would drop from £100 which gives a 30% yield down to £96 which gives a 35% yield ((130-96)/96 = 35%. (See diagram below)

This is the reason why a bond price would increase in case the interest rate drops. In case the interest rate of other bonds decreased to 15%, the zero-coupon bond which gives a yield of 30% will be very attractive to bond investors. Therefore, more people will buy a zero-coupon bond. In this situation, the price of the bond will push up until the bond’s yield matches the 15% rate. Therefore, the price of bond will now become approximately £112.9 ((130-112.9)/112.9 = 15%). At this point, when the bondholder decides to sell the zero-coupon bond, he/she will have an extra £12.9 from its original price of £100. Therefore, a decrease in the interest rate increases the price of bonds.