As an investor, it's important to understand the relationship between bonds and interest rates. After all, the U.S. fixed income market is by far the largest in the world, comprising 39.2% of the $128 trillion securities outstanding across the globe, according to SIFMA as of early 2022.
You might not be focused on how interest rates can impact bond prices, but you should still understand the relationship between the two. Keep in mind, bonds can be an important component of a diversified portfolio, and they'll likely become a more important part of your portfolio as you get closer to retirement. So, what does happen to bond prices when interest rates rise?
What happens to bonds when interest rates rise?
Most bonds and interest rates have an inverse relationship. When rates go up, bond prices typically go down, and when interest rates decline, bond prices typically rise. This is a fundamental principle of bond investing, which leaves investors exposed to interest rate risk—the risk that an investment's value will fluctuate due to changes in interest rates.
The relationship between interest rates and bond prices can be a little confusing at first, but it's important to understand so you can make informed investment decisions when considering bonds and other fixed income products.
If you intend to hold the bond to maturity, interest rate risk may be less of a concern for you as it'd be for someone who might need to sell the bond before it reaches maturity and may be forced to sell at a discount to par value, or below the bond's initial purchase price.
Most bonds are issued at or near par value, usually $1,000. The issuer receives this money when the bonds are first offered and, in return, promises to pay investors a stated fixed interest rate (the "coupon rate") at regular intervals with the intent of returning that initial investment of $1,000 back to bondholders at maturity.
After a bond is issued, it can be traded in the secondary market, causing the bond's price to fluctuate depending on supply and demand, changes in interest rates, and any news about the financial health of the issuer that could impact its ability to honor the obligations of the bond.
When interest rates rise, existing bonds paying lower interest rates become less attractive, causing their price to drop below their initial par value in the secondary market. (The coupon payments remain unaffected.) Current bond yields are calculated by dividing the annual interest payment by the bond's current price (current yield = annual coupon ÷ bond price). So, when the bond price drops, its yield increases, making it competitive against newer bonds paying higher rates.
In short, bond prices and bond yields move in opposite directions.
Here are two scenarios of investors buying bonds with the same par value but different interest rates.
Scenario 1: An investor buys a bond for $1,000 with a 10-year maturity and a coupon rate of 2%. The par value would be $1,000. The investor will receive annual interest payments of $20. After 10 years, the investor will receive their $1,000 principal, with $200 in interest, barring default.
Scenario 2: Meanwhile, interest rates rise and an investor buys a 10-year bond with a $1,000 par value that pays a coupon rate of 3%. The investor will receive annual interest payments of $30. After 10 years, they'll receive their $1,000 principal, after collecting $300 in interest.
So, the first bond then becomes less valuable because it's producing less income. Essentially, its market value declines. If the investor wanted to sell the first bond before the 10-year term ends, they'd likely have to sell it for less than $1,000. They'd lose money on the principal and would not receive the remaining interest payments. In this case, the rise in interest rates pushed the bond's market value lower.
What happens to bonds when interest rates fall?
When interest rates fall, bond prices typically rise, and there may be an opportunity to profit if an investor sells the bond before maturity. Let's assume an investor bought a bond with a 10-year maturity, a coupon rate paying 2%, and purchased it at its par value of $1,000.
But interest rates fall to 1%. Now, the coupon on their bond is more attractive than current market rates so investors would be willing to pay a premium—above par value—for the bond. If an investor sells when the bond is trading at a premium, they can profit from the capital appreciation as well as the income they've earned on the bond. However, if the investor was looking to reinvest those proceeds into another bond, they'd likely be faced with lower rates because the bond yield dropped.
Bottom line
When interest rates rise, bond values decrease. The impact, however, will vary according to each investor's individual circumstances. Learn more about the impact of rising interest rates for bond investors, as well as other areas of an investor’s portfolio, such as stocks and savings.
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Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.