Why Do Bonds Go Down When Interest Rates Go Up?

A bond represents a loan made by an investor to a corporation or government entity. In return, the issuer promises regular interest payments and repayment of the original amount borrowed at a specified future date. Interest rates signify the cost of borrowing money or the return earned on lending it. These rates influence various financial activities, including consumer loans, mortgages, and savings accounts.

Bond Fundamentals: Price and Yield Relationship

Bonds possess several characteristics that define their value and the return they offer. The “par value” or “face value” is the principal amount the bond issuer promises to repay at maturity, typically $1,000 for corporate bonds. The “coupon rate” is the fixed annual interest rate paid on this par value, determining the regular interest payments. For instance, a bond with a $1,000 par value and a 5% coupon rate will pay $50 in interest annually.

The “maturity date” is the specific date when the bond’s principal is repaid to the bondholder, marking the end of the loan term. While the coupon rate dictates the fixed payment amount, the bond’s “yield” reflects the actual return an investor receives, taking into account the bond’s current market price. This yield changes as the bond’s market price fluctuates.

A fundamental relationship exists between a bond’s price and its yield: they move in opposite directions. If a bond’s market price decreases, its yield to a new buyer will increase because the fixed annual interest payment represents a larger percentage of the lower purchase price. Conversely, if the bond’s price rises, its yield will fall. This dynamic governs how a bond’s effective return adjusts in the secondary market, even though its coupon payment remains constant.

Why Existing Bonds Lose Value When Rates Rise

When new market interest rates increase, existing bonds with lower fixed coupon rates become less attractive to investors. Newly issued bonds will offer higher coupon rates, aligning with prevailing market rates and providing a more appealing return. For example, if current market rates rise from 5% to 7%, a newly issued bond with a $1,000 par value might offer a 7% coupon, paying $70 annually.

This situation creates a disadvantage for older bonds that only pay, for instance, a 5% coupon or $50 annually on their $1,000 par value. To make these older, lower-coupon bonds competitive with the higher yields available from new issues, their market price must decrease. This price adjustment effectively increases the yield for a new buyer to match the higher returns available in the current market.

The decline in price means that if an investor needs to sell an existing bond before its maturity date when interest rates have risen, they may receive less than the original amount paid. This market adjustment ensures that all bonds, regardless of their original coupon rate, offer a comparable yield based on current market conditions. The fixed nature of a bond’s coupon payments means that price changes are the primary mechanism through which its yield adjusts to prevailing interest rates.

Market Response and Investor Decisions

The inverse relationship between bond prices and interest rates significantly influences investor behavior and market dynamics. When market interest rates rise, investors naturally seek the highest possible return for their capital. This leads them to favor newly issued bonds that offer higher coupon rates, reflecting the increased cost of borrowing.

The demand for these new, higher-yielding bonds increases, while demand for older bonds with lower fixed coupon rates diminishes. This shift in investor preference contributes to downward pressure on the prices of existing bonds in the secondary market. Current bondholders who wish to sell their bonds before maturity may find they must do so at a discount to their original purchase price to attract buyers.

This is because potential buyers can achieve a better return by purchasing newly issued bonds at current market rates. The overall effect is that bond portfolios held by investors experience a decrease in value when interest rates climb.

While this can result in short-term capital losses for existing bondholders, it also presents opportunities. Investors can reinvest maturing funds or new capital into bonds offering higher yields, potentially enhancing their portfolio’s income stream over time. This dynamic underscores why understanding interest rate movements is important for managing fixed-income investments effectively.