Why Bond Prices Fall When Interest Rates Rise

An ongoing national financial literacy study published by the Financial Industry Regulatory Authority (FINRA), found that most Americans cannot correctly answer the following question: “If interest rates rise, what will typically happen to bond prices?” You may think you're a savvy investor, but do you know the answer? Only 28% of Americans were able to answer this. That, of course, means 72% of people don’t know that bond prices generally fall when interest rates rise. Understanding the relationship between bond prices and interest rates can help you avoid watching the "safer" portion of your portfolio decline far more than you might have expected or thought possible.

Understanding the relationship between bond prices and interest rates is relevant to you whether you own individual bonds, bond mutual funds, exchange-traded funds (ETFs), or have a portion of your 401(k), 403(b) or other qualified plans invested in bond investments. (For related reading, see: Interest Rates and Your Bond Investments.)

How Do Bonds Work?

When you buy a bond, you effectively lend money to the issuer of that bond. The issuer agrees to pay you back in full at the bond’s predetermined maturity date. In the meantime, the issuer will also pay you interest. Just as with any other loan, interest is the fee for borrowing the money and repaying it at a later date. The amount of interest is fixed at the time you purchase the bond (unless you purchased what is known as a floating rate or step-up rate bond).

No matter what the market does, your interest rate is locked in.

Here’s an example: If you purchase a 10-year, $1,000 bond with a fixed 5% interest rate. You would earn $50 in interest from the bond each year ($1,000 x 5% = $50). You’ll earn a total of $500 in interest by the bond’s maturity date ($50 x 10 = $500). The issuer of the bond must also repay the amount they borrowed. At the end of the 10-year period, then you’d have $1,500 ($1,000 initial bond amount + $500 in interest).

Most bonds are pretty simple, straightforward and relatively safe investments. But there are numerous types of bonds issued by a wide range of companies and government entities, all of which carry different levels of credit risk (risk of default) that you should understand.

What Causes Bond Prices to Fluctuate?

In addition to bonds being impacted by interest rates, which is discussed further below, bond prices are also impacted by a number of other factors, including an issuer's credit rating which is determined by credit rating agencies (similar to how you as an individual have a credit score from FICO).

The bond credit rating indicates how likely an issuer will be able to repay you as an investor, both in interest and for the original bond amount. Better credit ratings usually equate to lower yields when you purchase bonds from these issuers as they’re more likely to repay the debt. That means you generally take less risk as an investor in bonds with strong credit ratings, but the trade off is they earn less interest than issuers with lower ratings.

If a bond you own has its credit rating reduced before it matures, its value will likely decline, thereby increasing their yield to compensate for the increased default risk. In addition to credit ratings, inflation impacts bond prices too. Rising inflation means that the dollar you have today doesn’t buy as much as it did yesterday.

Deflation would give you more buying power, making your dollar stronger. Bond prices reflect this. When inflation rises, bond prices fall because what you’ll earn at maturity will be worth less due to a weaker dollar. And bond prices rise during periods of deflation because the amount earned at maturity is worth more. (For related reading, see: 6 Biggest Bond Risks.)

Other factors that influence bond price include: the type of bond, the time to maturity, the frequency of interest payments and interest rates. Bond prices increase when interest rates fall and bond prices decrease when interest rates rise. Why is this?

The Relationship Between Bond Prices and Interest Rates

If you bought a 10-year, $1,000 bond at 5% interest (called the coupon rate) last year but one year later interest rates are at 6%, you'd have a hard time convincing a buyer. They would have to settle for receiving a 5% interest rate, when they could buy a new bond that now pays a 6% interest rate.

Most bond’s interest rates don’t change over the life of the bond. In order to entice someone to buy your 5% bond, you would need to sell your bond at a discount. How much of a discount typically depends on how long the new bond holder has to wait until the bond matures.

Here is an example: A potential buyer for your 5%, $1,000 face amount bond with nine years left to maturity, may only be willing to pay you $932, instead of the $1,000 you paid for it only a year ago. By paying you $932 versus the $1,000 price you paid, the new buyer will earn their desired 6% yield to maturity (nine years of $50 coupon payments, plus the $68 principal gain at the bonds maturity) that equates to a 6.8% drop in the value of your bond if you were to sell it rather than hold to maturity.

Duration is a measure of a bond or bond mutual fund or exchange-traded fund's (ETF) sensitivity to rising interest rates and is calculated based on the weighted average of the time period until a bond or bond portfolio’s interest and principal payments are received. The higher the duration number, the more sensitive your bonds will be to changes in interest rates, both up, and down.

A quick rule of thumb to use to determine your bond portfolio's vulnerability in a rising rate environment is to start by determining your bond or bond mutual fund’s / ETF’s duration (which can often be found on the mutual funds/ETF’s fact sheet or current research report). Generally speaking, a duration of 10 would mean for every 1% rise in interest rates your bond investments value would fall by 10%. A duration of five  would equate to a 5% drop in value for each 1% rise in rates, and so on. As you can see, the higher the duration, the higher the risk level of your bond holdings and vice versa.

In a rising rate environment you typically want your bond holdings to have the lowest duration possible to protect the value of your principal from potentially precipitous declines if interest rates rise quickly. Of course, this works the other way around, too. If interest rates fell, your bond price would likely go up.

What Else You Need to Consider

In addition to the relationship between interest rates and bonds, there are other things to be aware of when investing in bonds. Be aware of if you’re investing in callable bonds. This means the issuer can retire the bond before it reaches maturity. This is more likely to happen if interest rates begin to climb. Most bonds come with investor protections that state even if a bond is called, you’ll still receive your payments for a certain number of years. Review the terms of your bond carefully to determine its callable status and protections.

If investing U.S. government bonds, bond funds or ETFs, one common misconception is you have nothing to worry about when interest rates rise, as your principal is guaranteed by the U.S. Treasury. This is not always the case. If you own a U.S. government bond mutual fund or ETF, your principal can fluctuate just like any other bond fund when interest rates rise or fall. 

You should never invest in something you don’t understand and bonds are no exception. Know what you own in your portfolio and how to apply this newfound knowledge to make smarter investment decisions and take the appropriate amount of risk for you. (For related reading, see: Bond Basics: Bond Prices and Yield to Maturity.)

 

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