Why bond prices fall when interest rates rise
This is informational and not financial advice.
Bonds are usually introduced as the safe half of a portfolio, which leaves people unprepared for the years when the safe half falls. Nothing has gone wrong when that happens. It is the mechanism working exactly as designed, and the arithmetic behind it fits in a single table.
The mechanism in one table
A bond is a loan with fixed terms. You lend $1,000, the borrower pays a fixed amount each year, and returns the $1,000 at the end. Suppose the fixed payment is three per cent, so $30 a year for ten years, then $1,000 back.
Those payments never change. They were written into the contract on day one. What changes is what the market will pay you for the right to receive them.
| If market rates are | Your bond is worth | Change |
|---|---|---|
| 1% | $1,189 | +18.9% |
| 2% | $1,090 | +9.0% |
| 3% | $1,000 | par |
| 4% | $919 | −8.1% |
| 5% | $846 | −15.4% |
| 6% | $779 | −22.1% |
Read the middle row first. When the market rate equals the coupon, the bond is worth exactly its face value, because it pays exactly what a new bond pays. Every other row is the market correcting for the fact that it does not.
Why the old bond has to get cheaper
The reasoning is short enough to follow without algebra.
Rates rise to five per cent. A newly issued $1,000 bond now pays $50 a year. Yours pays $30. Nobody will pay $1,000 for $30 a year when $1,000 buys $50 a year next door.
So your bond does not sell for $1,000. It sells for whatever price makes $30 a year plus $1,000 at the end add up to a five per cent return for the buyer. That price is $846. The $154 discount is precisely the compensation for the smaller coupon, worked out over the remaining life of the bond.
Nothing was lost through failure. The issuer is still paying. You still get $1,000 at maturity. What fell is the price someone else will pay today for a contract that has become less attractive than the alternatives — the same present-value arithmetic that sets the number in how mortgage rates are set, running in the other direction.
Longer bonds move much more
Here is the part that decides how much a rate move actually costs you. Take the same three per cent bond, apply the same one-point rise from three to four, and change only how many years are left.
| Years remaining | Price at 3% | Price at 4% | Fall |
|---|---|---|---|
| 2 | $1,000 | $981 | −1.9% |
| 5 | $1,000 | $955 | −4.5% |
| 10 | $1,000 | $919 | −8.1% |
| 20 | $1,000 | $864 | −13.6% |
| 30 | $1,000 | $827 | −17.3% |
Same borrower, same coupon, same one-point move. The thirty-year bond falls roughly nine times as far as the two-year.
The reason is that a below-market coupon is a small disadvantage repeated for as long as the bond has left to run. Two years of being $20 short is a minor inconvenience. Thirty years of it is a serious one, and the price today reflects the whole run.
This sensitivity has a name, duration, and it is the single most useful number on a bond fund’s page. A fund reporting a duration near seven will lose roughly seven per cent of its value for each one-point rise in rates, and gain roughly that much when rates fall.
Why a bond fund behaves differently from a bond
Hold an individual bond to maturity and the price swings in between are noise. You were promised $1,000 on a date and you receive it, whatever the quoted price did along the way.
A fund has no such date. It holds many bonds, sells them before maturity and buys new ones, so what you own is a rolling portfolio permanently marked at today’s prices. There is no moment when it returns to par.
That is why a bond fund can post a losing year while every bond inside it pays on schedule, and it is the most common surprise for people who bought the fund expecting the behaviour of the bond. It is the same distinction between an asset and a wrapper that shows up in how index funds work.
The compensation is real, though slower than the loss. As the fund replaces maturing bonds with new higher-coupon ones, its income rises. Over a period roughly equal to its duration, the extra income tends to offset the price fall.
What the headline yield does not tell you
Two figures get quoted and they answer different questions.
Current yield is the annual coupon divided by the price. It ignores the fact that a bond bought at $846 pays back $1,000, so it understates the return.
Yield to maturity includes that repayment, spread over the remaining years. It is the figure worth comparing across bonds, and it is what the tables above are solving for.
Neither adjusts for inflation. A three per cent return while prices rise at three per cent preserves your money and grows nothing, which is the same distinction between nominal and real that governs compound interest.
What follows from the arithmetic
Match the duration to when you need the money. If the money is spent in three years, a fund with a duration of twelve is exposed to a variable that has nothing to do with your plans.
Read a fall in a bond holding as a change in price, not as a default. The two look identical on a statement and are completely different events.
And treat a rate rise as arriving with a compensation attached. The price drops at once; the higher income arrives gradually. Selling in between is the one decision that converts the first without collecting the second.
Sources
- TreasuryDirect, Treasury bonds — coupon, maturity and redemption terms as issued
- Federal Reserve, H.15 Selected Interest Rates — the market rates the prices above are measured against
- SEC Investor.gov, bonds — the regulator’s definition of a bond and of the inverse relationship between price and yield