Why Do Bond Prices Go Down When Interest Rates Rise?
Here’s what you need to know about how bond prices are calculated
Bonds can be an attractive investment because they’re generally less risky than stocks, because the bond issuer has a promise to repay bonds. Depending on your risk tolerance and when you need access to your investment funds, a diversified portfolio with a mix of stocks and bonds can maximize your returns while also limiting your exposure to risk or even offsetting more volatile investments.
But the way bond prices are calculated can be a little tricky. Even if you’re not likely to purchase individual bonds for your portfolio—many mutual funds include or are made up entirely of bonds—it can still benefit you to understand how they work and how bond prices are calculated.
Why Bond Prices Change When Interest Rates Change
When interest rates rise, bond prices fall, and when interest rates go down, bond prices increase. This inverse relationship can seem a little confusing at first glance, but a real-life example can provide a better sense.
Before we get into that example, let’s lay some groundwork. Unlike stocks, which represent ownership in a company, bonds are a type of loan made by an investor, typically to a company or government agency. In return, the investor receives fixed-rate interest income, usually semiannually, which remains the same despite how market interest rates might change.
Loans are usually classified as short-term, medium-term, or long-term, based on how soon they repay the principal to investors.
Bonds essentially compete against one another on the interest income they provide to investors. When interest rates go up, new bonds that are issued come with a higher interest rate and provide more income to investors. When rates go down, new bonds issued have a lower interest rate and aren’t as attractive as older bonds.
Unfortunately, when rates go up, the older, lower-rate bonds can’t increase their interest rates to the same level as the new, higher-interest bonds. The older bond rates are locked in, based on the original terms.
As a result, the only way to increase competitiveness and value to new investors is to reduce the price of the bond. But as a result, the original bondholder may be holding an investment that has decreased in price—and doesn’t pay out as much as they could get for it right now on the market.
The term “duration” measures a bond’s sensitivity or volatility to market interest rate changes, and takes into account the coupon payments and the date the bond matures. A bond’s duration is expressed in terms of years, and helps you compare different bonds or bond funds. The longer the duration of a bond, the more sensitive it is to interest-rate changes.
A Bond Example
Let’s say you purchase a bond with a par value (or loan principal) of $1,000 that has 10 years until the loan principal is repaid. On the date the bond matures, you’ll get the original $1,000 back.
The bond has a 3% coupon (or interest payment) rate, which means the bond pays you $30 a year. If you’re paid semiannually, or every six months, you’ll receive $15 in coupon payments.
You want to sell your bond one year later, but the market interest rate has increased to 4%. Because buyers can now easily purchase a $1,000 bond with $20 semiannual coupon payments, your $15 coupon payment doesn’t look so great.
- New bond: The buyer would receive $40 annually for 10 years for a total of $400.
- Your bond: The buyer would receive $30 annually for nine years for a total of $270.
To create an incentive for the buyer, your bond must be sold at a discount, in some way. They would need to purchase your bond from you for $925 instead of the $1,000 you paid a year earlier. But how is this number decided upon?
How Much Will Bonds Fall When Interest Rates Rise?
There’s a rather complex formula to figure out roughly how much the discount might be, which takes into account these variables:
- Today’s interest rates
- How many coupon or interest payments you expect to receive until it matures
- Amount of each coupon payment
- The future bond value or face value
For example, if you purchased a $1000 Bond at 3% interest, which had 18 coupon payments remaining of $15 each, this is how an increasing interest rate environment would impact the market value of your bond.
|Today's Interest Rate||Market Value|
Here’s how a decreasing interest rate environment would impact the same bond:
|Today's Interest Rate||Market Value|
Interest rates are among the most influential factors, but the current price of any bond is based on several factors, including type of bond, market conditions, and duration.
Rising Rates for Bond Funds vs. Individual Bonds
Individual bonds can provide a reliable income stream while maturing, and predictable payment at maturity. But it can be challenging to diversify your portfolio and limit your exposure to interest-rate risk with individual bonds alone.
A bond fund or bond ETF that invests in a large array of different bonds can help mitigate the risk accompanying interest-rate fluctuations. For example, if you have just one bond with a duration of seven years and another with a duration of three years, the second bond helps mitigate your total risk exposure.
Now, consider that bond funds invest in a large number and sometimes different types of bonds, magnifying that effect. With this diversity, bond funds tend to provide more protection against rising interest rates than do individual bonds. They also mitigate default risk and call risk (when the borrower buys back the bond before the maturity date).
Should You Buy Bonds When Rates Are Rising?
Interest rates will always fluctuate, and it’s impossible to predict how they’ll change over time. Whether interest rates are rising or falling, it’s important to consider your yield to maturity for any existing bond purchase, and compare it with what you could get if you were to purchase a new bond.
Bond pricing can be complex, however, so consider working with a financial advisor, who can help you run the numbers and determine whether a particular bond purchase is a good idea for your situation.
The Bottom Line
Bonds can be an essential part of a well-balanced portfolio, but understanding how they’re priced when interest rates rise can be challenging. Unless you enjoy the intricacies of the process, you may be better off investing in bond mutual funds or ETFs, which can help reduce your risk and also leave the number-crunching to professionals.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.