Why Bond Prices Fall When Interest Rates Rise
A bond is a loan with a fixed payment. Here is why its market price moves the opposite way to interest rates, and how yield and duration measure that move.
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A bond's market price moves in the opposite direction to interest rates. When rates rise, existing bonds usually fall in price; when rates fall, they usually rise. The reason is simple once you see a bond as a loan with a fixed schedule of payments. This article explains the parts of a bond, why the price and the rate pull against each other, and what yield and duration tell you. It is general information, not advice about what to buy or sell.
What a bond is
A bond is a loan. The buyer lends money to an issuer, such as a company or a government, and the issuer promises to pay interest and to repay the original amount on a set date. According to FINRA, the US securities industry regulator, most bonds have a maturity date on which the issuer repays the face value, also called par value.
The coupon is the yearly interest, set when the bond is issued and quoted as a percentage of par. FINRA gives the example of a bond with a face value of $1,000 and a 4.5% coupon: it pays $45 a year, usually as two payments of $22.50. The coupon normally stays the same for the life of the bond, even though the price people will pay for the bond on the market changes every day.
Why the price moves against rates
Imagine you hold a bond that pays a 4% coupon. Later, market interest rates rise, and new bonds of similar quality are being issued with a 5% coupon. Nobody will pay full price for your 4% bond when a 5% bond is available for the same money. To find a buyer, you must lower the price until the bond's overall return matches what new bonds offer. FINRA states it directly: when interest rates rise, bond prices generally fall.
The reverse also holds. If rates drop to 3%, your 4% bond now pays more than new bonds do, so buyers will pay a premium for it. Bond prices are quoted as a percentage of par. A price of 105 means $1,050 for a $1,000 bond, and a price of 95 means $950.
How price is worked out
The standard method treats a bond's price as the present value of all the cash it will pay. Each future coupon, and the final repayment, is discounted back to today using the market rate of return. Wikipedia's article on bond valuation gives a small example. A bond has two half-year periods left, pays a coupon of 3 per period, repays 100 at the end, and is discounted at 3.5% per period. Its price is about 3 divided by 1.035 plus 103 divided by 1.035 squared, which comes to roughly 99.05.
Notice what happens if the discount rate goes up. Every payment is divided by a bigger number, so the total shrinks. A higher market rate means a lower price, and a lower market rate means a higher price. The payments themselves have not changed; only the rate used to value them has.
Coupon, current yield and yield to maturity
Because the price changes, the coupon alone does not describe what a buyer earns. Two other measures are used.
- Current yield is the yearly coupon divided by the current price. Wikipedia's example has a yearly coupon of 6 and a price of 98.20, giving a current yield of about 6.11%.
- Yield to maturity is the single discount rate that makes the present value of all remaining payments equal to the market price. It assumes the bond is held to maturity and that the issuer pays everything on time.
- For a bond trading below par, the yield to maturity is higher than the current yield, which is higher than the coupon rate.
When people say a bond's yield has risen, they usually mean its yield to maturity. A falling price and a rising yield are two ways of describing the same event.
Duration: how sensitive is the price?
Not all bonds react equally. Duration, measured in years, estimates how much a bond's price may change for a one percentage point change in yield. Wikipedia's example is a bond with a duration of 7: if its yield rises by one percentage point, its price falls by about 7%, ignoring a smaller second-order effect called convexity. Bonds with longer maturities and lower coupons generally have higher durations, so their prices swing more when rates change.
Other risks besides interest rates
FINRA lists several other risks that sit alongside interest rate risk.
- Credit risk: the issuer may miss payments. Credit ratings are one way to judge it, and US Treasuries are generally regarded as free of default risk.
- Call risk: the issuer may repay a callable bond early, often when rates have fallen, forcing the holder to reinvest at lower yields.
- Inflation risk: fixed payments lose buying power when prices rise. Inflation-linked bonds such as TIPS adjust the principal to address this.
- Liquidity risk: some bonds trade rarely and may be hard to sell at a fair price.
- Currency risk: for foreign bonds, exchange-rate moves can raise or cut the return.
Putting it together
A bond's fixed payments are what make its price sensitive to rates. A higher rate lowers what those payments are worth today; a lower rate raises it. Yield to maturity expresses the return implied by the price, and duration estimates how far the price might move. Understanding these three ideas explains most headlines about bond markets, though real-world prices also reflect credit quality, supply and demand, and expectations about future rates.
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