Why Do Bond Prices Go Down When Interest Rates Rise?
Bond prices change when interest rates change. Here's why.
Bond prices rise when interest rates fall, and bond prices fall when interest rates rise. Why is this? Think of it like a price war; the price of the bond adjusts to keep the bond competitive in light of current market interest rates. Let's see how this works.
Why Bond Prices Change When Interest Rates Change
A dollars and cents example offers the best explanation of the relationship between fixed-rate bond prices and interest rates. Let's look at a case study.
Case Study Facts
- You buy a bond for $1,000.
- It matures in ten years (at which time you get back your $1,000 investment).
- Its coupon rate (interest rate) is 3%, so it pays 3% a year, or $30 a year.
Suppose one year after you purchase the bond interest rates rise to 4% and you decide to sell your bond.
When you enter an order to sell, the order goes to the market, and potential buyers now compare your bond to other bonds and offer you a price.
How does your bond compare to other bonds on the market? Since interest rates went up, a newly issued $1,000 bond maturing in three years, the time left before your bond matures is paying 4% interest or $40 a year.
Market Adjustment to Bond Prices
Your bond must go through an adjustment to be fairly priced when compared to new issues. Let's take a look at how this market adjustment works, if you're selling after holding the bond for one year.
If an investor buys your bond for $1,000, they will receive $30 x 9, or $270 in interest over the remaining 9 years.
If an investor buys a new bond for $1,000, they will receive $40 x 10, or $400 in interest over the remaining 10 years.
There is no incentive to buy your bond at its face value of $1,000, since the investor would receive less interest than the newly issued bonds. So the market adjusts the price of your bond to make it equivalent.
In this set of circumstances, you may receive an offer of about $925 for your bond.
When a bond sells for less than its maturity value it is said to trade at a discount.
An investor who bought your bond for $925 would now benefit from a 4% yield to maturity.
Because they were able to pay less for the bond, they would receive the same dollar amount of profit, over the same time frame, as if they bought a newly issued bond paying a higher interest rate.
If you hold your bond to maturity, you receive the full $1,000. The current market price of the bond only matters if you are selling your bond now.
Individual bonds may be a good choice when you want a certain outcome or amount back. You know how much you'll get and when you'll get it, and you don't have to worry about the price fluctuations.
For retirement income, individual bonds are frequently used in what is called a bond ladder to create an annual stream of cash flow that is used to live on in retirement.
Bond Prices, Interest Rates, and Duration
There is a formula you can use to estimate the effect a change in interest rates will have on a bond or bond fund. In the white paper, "The 4 Percent Rule is Not Safe in a Low-Yield World," authors Michael Finke, Wade Pfau, and David Blanchett state:
"One method to approximate the impact of a change in interest rates on the price of bonds is to multiply the bond’s duration by the change in interest rates times negative one.
For example, if interest rates increase by 2%, a bond with a duration of 5 years (the approximate current duration of the Barclays Aggregate Bond index) would decrease in value by 10%. The impact on bonds with longer durations (e.g., 15 years) would obviously be even more extreme."
To use this formula, you must understand and look up a bond's duration. In simple terms, the duration is a weighted average measuring the length of time the bond will pay out.
The higher the duration, the more sensitive the bond or bond fund will be to changes in interest rates.
Other Factors that Influence Bond Prices
The example provided does not account for all factors that affect a bond's market price. The final price of a bond depends on the credit quality, type of bond, maturity, and frequency of interest payments. In general, bonds with similar terms will adjust to interest rates in a like manner.
Warning: Along with duration risk, bonds come with risks such as credit risk, default risk, and other risk factors.
If you own a bond fund, the price of the shares of the fund will reflect the collective pricing on all the bonds owned by the bond fund.
What Type of Bonds Fare Well in a Rising Interest Rate Environment?
There are two types of bonds that may not go down when interest rates rise. Both floating rate bond funds and inflation-adjusted bond funds may maintain their value in a rising interest rate environment because the interest payments on these types of bonds will adjust.
If you own individual bonds rather than bond funds and plan to hold your bonds to maturity, then you will not need to be as concerned about changes in interest rates as you have no plans to sell your bond. The bond's interim price is irrelevant to you.
How About Bonds Vs. Stocks?
Historically, there has been an inverse relationship between stocks and bonds. When stocks go up, bonds go down. The reverse is also true. Why? You'll find many reasons cited—some more accurate than others. The prevailing reason is that when the stock market takes a negative turn, investors may transfer their money into bonds as a safety play.
Also, stocks are tied to market performance where bonds are tied more to interest rates. When the economy is not as strong, central bankers may lower interest rates to stimulate growth. Lower interest rates mean bond prices go up but a weak economy is probably sending stock prices lower.
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.
SEC. "Investor Bulletin: Interest Rate Risk–When Interest Rates Go Up, Prices of Fixed-rate Bonds Fall." Accessed March 12, 2020.
Morningstar. "Low Bond Yields and Safe Portfolio Withdrawal Rates." Accessed March 12, 2020.
FINRA. "Get a Handle on Your Risk: 5 Things To Know About Bond Duration." Accessed March 12, 2020.