Bonds & Interest Rates · Intermediate · 5 min

Why bond prices fall when rates rise

You can explain why the price of an existing fixed-rate bond moves opposite to market interest rates, and why longer bonds move more.

Safe, and falling?

Bonds have a reputation for being the calm part of a portfolio. Then a year comes when central banks raise rates quickly, and bond funds lose more than many people thought possible.

How can a bond, with its fixed payments, lose value? The answer is one of the most important ideas in all of investing, and it is simple once you see it from the buyer's side.

Rates up, prices down

A fixed-rate bond pays the same coupon until it matures. The market around it does not stand still.

Imagine you own a bond paying 3% a year, and market interest rates rise, so new bonds of the same quality now pay 4%. Why would anyone pay full price for your 3% bond when they can get 4% elsewhere? They would not. Your bond's price has to fall until a buyer earns about the same as with a new bond. When rates fall, the opposite happens: your 3% bond becomes attractive, and its price rises.

The SEC calls this interest rate risk, and states the rule plainly: market interest rates and bond prices generally move in opposite directions.

Two things decide how strongly a bond reacts:

Maturity. The longer a bond runs, the longer its holder is stuck with the old coupon. The SEC notes that bonds with longer maturities generally have higher interest rate risk than similar bonds with shorter maturities.
Coupon. A bond with a lower coupon reacts more than one with a higher coupon, because more of its value lies in the repayment far in the future.

Holding to maturity changes the picture. If the issuer can pay, it repays the face value at the end, whatever happened to rates in between. The price loss is then temporary. It becomes real if you sell early. A bond fund has no maturity date, so its losses after a rate rise are recovered only slowly, through higher income over time.

925 vs. 1,082

The SEC uses this example: a Treasury bond with a 3% coupon and a face value of 1,000, with about nine years left until maturity.

If market rates rise to 4%, its price falls to about 925. A buyer then earns about 4% a year until maturity, through the coupon plus the gain to 1,000.
If market rates fall to 2%, its price rises to about 1,082.

A one-point change in rates moved the price by about 7.5% in either direction. A bond with 20 years left would have moved even more.

Common mistakes

"Bonds can't lose value." Fixed-rate bonds lose value when rates rise.
Buying long bonds for safety. Longer maturity means more interest rate risk.
Selling in panic after a rate rise. Held to maturity, a solid bond still repays its face value.
Treating a bond fund like a single bond. A fund never reaches a fixed maturity.

The takeaway

When new bonds pay more, old ones with lower coupons are worth less. That is why bond prices fall when rates rise, and longer bonds fall most.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the case in which the existing bond loses value.

Tap the chart.

New bonds now pay 4%, so a buyer pays less for a 3% bond: about 925, as in the SEC's example.
2Which bond usually reacts more strongly to a rise in rates?

The SEC notes that bonds with longer maturities generally have higher interest rate risk.
3You hold a high-quality bond to maturity. Rates rose in between. What do you receive at the end?

Price swings matter if you sell early. Held to maturity, the issuer still repays the face value, if it can pay.
4Two bonds have the same maturity, one with a 2% coupon, one with 4%. Rates rise. Which price falls more?

The SEC's bulletin points out that the lower-coupon bond falls more when rates rise.

of 4 correct.