What Happens to Bonds When Interest Rates Rise?
Bond prices and interest rates are intertwined, almost by definition, as the movement of the latter directly impacts the price action of the former. Bonds pay a fixed interest rate that can be the foundation of a diversified portfolio—especially as risk tolerance decreases during an investor's lifetime—so the interest-rate environment is fundamental to fixed income investing. The relationship between rates and bond values is simple: When rates go up, bond prices go down. When rates go down, bond prices go up. And existing bonds' attractiveness, relative to new bonds on the market, will be judged as market rates change.
This inverse relationship between bonds and interest rates shapes the structure of the financial markets. Bond rates, or yields, are set by several factors, some of which are objective—like time until maturity and credit rating—and some that are more nuanced, such as inflation projections and liquidity. As economies evolve and central bank policies change, the effect on rates, and therefore bond yields, ripples through portfolios and contracts. That's why investors need to consider impending interest rate changes when structuring their portfolios, especially when it comes to their fixed income selections.
What happens to bonds when interest rates rise?
A fundamental principle of bond investing is that when interest rates rise, bond prices typically decrease. This leaves investors exposed to interest rate risk—the risk that an investment's value will fluctuate due to changes in interest rates.
For investors who intend to hold a bond to its maturity date, interest rate risk may be less of a concern than for others who might need or want to sell the bond before it reaches maturity. Bond investors with this kind of shorter-term view 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—typically a government, corporation, financial institution, or municipality—receives this money when the bonds are first offered and, in return, promises to pay investors a fixed interest rate (the "coupon rate") at regular intervals. At maturity, and barring any extenuating circumstances, the issuer returns the initial investment of $1,000 back to bondholders.
Bonds can be bought and sold in the secondary market after they're initially issued. This activity causes a bond's price to fluctuate depending on supply and demand, changes in interest rates, and any news about the issuer's financial health that could impact its ability to honor the bond's obligations.
When interest rates rise, existing bonds paying lower interest rates become less attractive, typically causing their value to drop below their initial par value in the secondary market. (The regular interest payments remain unaffected.) A bond's "current yield" is calculated by dividing the annual interest payment by the bond's current price. So, when the bond price drops, its yield increases, making it competitive against newer bonds paying higher rates.
Rising-rate examples
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 is $1,000, and the investor will receive annual interest payments of $20. After 10 years, the investor will have collected $200 in interest and will receive their $1,000 principal back, barring default from the issuer.
Scenario 2: In a rising interest-rate environment, another investor buys a 10-year bond with a $1,000 par value that pays a coupon rate of 3%. This investor will receive annual interest payments of $30. After 10 years, they'll receive their $1,000 principal and have collected $300 in interest.
After interest rates shift, the first bond is considered less valuable because it's producing less income than the bonds that are currently available. If the investor wanted to sell the first bond before its 10-year term ends, they'd likely have to sell it for less than $1,000 because there are more attractive alternatives available. 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 first bond's market value lower.
What happens to bonds when interest rates fall?
On the flip side, when interest rates fall, bond prices typically rise so there may be an opportunity to profit if an investor sells their bond before maturity. Here's the previous example but in the opposite direction.
Let's assume an investor bought a bond with a 10-year maturity at a coupon rate paying 3% and purchased it at its par value of $1,000. But then suppose interest rates fall to 2%. The 3% coupon on their bond is now 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 while holding the bond. However, if the investor was looking to reinvest those proceeds into another bond, they'd likely face lower rates amid falling yields.
Bottom line
When interest rates rise, bond values decrease, and vice-versa. This is a fundamental relationship in investing, and its effects are generally greater the longer the time there is to a bond's maturity. This trade-off between rates and prices ripples through the economy, reaching beyond bond investors to influence prices in other markets.
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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.
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This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned 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 decisions.
For illustrative purpose(s) only. Individual situations will vary. Not intended to be reflective of results you can expect to achieve.
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