do you think it is necessary for bond prices to fluctuate in response to changing interest rates?

Answer 1

Absolutely.

Once a bond is issued, the interest rate can not change.

When a company issues a bond, it must specify an amount and an interest rate prior to it being issued. So lets say we have “Company A” and that the prevailing rate for a company with an “A” credit rating for a bond issued 10 years is 5%. The bonds have the typical face value of $1000, so each year, you will receive $50 in interest.

A year later, Company B has the same credit rating and issues a 10 year bond. The interest rates for the same bond are now 7%. For a $1000 bond, a buyer would get $70 in interest per year.

The person that bought the bond for Company A is only getting $50 a year in interest and the person who bought an identical bond for Company B one year later is getting $70.

Now say a person wants to buy a bond from Company A or B on the secondary market. If they were the same price, the person would buy a bond from Company B because it is paying a higher interest rate.

In order to sell the bond for Company A, the holder now has to change the price. If the current prevailing interest rate was 7% and the person was selling a 5% $1000 bond, they would have to reduce the price to make the bond more competitive with the current 7% bonds. There are equations involved where you can calculate what the cost of a bond will be (and to be honest, I don’t remember them anyway).