Why Do Bond Prices Fall When Interest Rates Rise?

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Bond prices fall when interest rates rise because a bond’s payments are fixed when it is issued, while the market’s required rate of return keeps changing. Suppose new bonds start paying more. An older bond paying less now has to sell for a lower price before anyone will buy it. That lower price raises the return a new buyer earns until it matches the higher rates on new issues. When rates fall, the process runs the other way: older bonds with higher coupons become more valuable, and their prices rise.

This inverse link holds for all fixed-rate bonds, from U.S. Treasuries to corporate and municipal debt. How far the price moves depends on time to maturity, the timing of cash flows and whether the payments are fixed at all.

A fixed payment repriced to a moving market rate

A conventional bond promises a set stream of cash. It pays a coupon (the annual interest, stated as a percentage of face value) and returns the face value, or par, at maturity. None of those amounts change after issuance. The only thing that can adjust when market conditions shift is the price.

Suppose you own a bond paying $30 a year on $1,000 of face value, and new bonds of similar quality and maturity start paying $50 a year. Your bond’s $30 can’t change, so a buyer will only take it at a discount. The discount has to be large enough that the $30 coupons plus the gain from the discounted price up to $1,000 at maturity match the new bond’s return.

The same logic works in reverse. If new bonds pay only $20 a year, buyers will bid your $30 bond above par until its return falls to the market level.

Price and yield are two views of the same number

A bond’s price is what you pay to buy it. A new bond can be sold at, above or below face value, depending on its terms. After that, it trades between investors at whatever price the market sets.

A bond’s yield is the return you earn at that price. The simplest version is current yield:

Current yield = annual coupon payment ÷ current price

The coupon payment stays fixed, so a lower price produces a higher yield and a higher price produces a lower yield. Take a bond paying $40 a year. At a price of $1,000, its current yield is 4%. At $800, the same $40 is a 5% current yield.

The fuller measure is yield to maturity (YTM). YTM is the single discount rate that makes the present value of all the bond’s remaining cash flows equal its price. Put another way, the price is each coupon and the final principal payment, discounted back to today at the same rate, then added together. That rate is the yield. When the market demands a higher discount rate, every future payment is worth less today, so the price must fall. This is why “bond yields rose” and “bond prices fell” describe the same event.

Worked example: a one-year zero-coupon bond

Zero-coupon bonds show the mechanism most clearly. They pay no periodic interest. They are sold at a discount and pay full face value at maturity, so all of the return comes from the gap between purchase price and par.

Hypothetical example. A zero-coupon bond with $1,000 face value matures in one year and trades at $950.

• Return to maturity: (1,000 − 950) ÷ 950 = 5.26%

If market rates rise to 10%. New one-year bonds now yield 10%, and nobody will pay $950 for a 5.26% return. The price must fall until the bond also yields 10%:

• New price = 1,000 ÷ 1.10 = about $909.09

The bond still pays $1,000 in a year. What changed is the price a buyer will pay today for that $1,000.

If market rates fall to 3%. The 5.26% return now looks attractive, and buying pushes the price up until the yield matches 3%:

• New price = 1,000 ÷ 1.03 = about $970.87

An investor who bought at $950 and sells at $970.87 has a gain without waiting for maturity. Rising rates do the opposite to anyone who must sell early.

Why maturity changes the size of the drop

Longer bonds move much more, because a change in the discount rate compounds over every year until each cash flow arrives.

Hypothetical comparison, all with $1,000 face value, annual payments and a market rate rising from 3% to 5%:

Two patterns stand out. The 10-year bond loses about four times as much as the 2-year bond for the same rate change. And the 10-year zero falls further than the 10-year coupon bond. The coupon bond returns some of its cash early through coupons. The zero holds everything until the final day, so all of its value sits at the most rate-sensitive point.

The bond market measures this sensitivity with duration. Duration reflects how long, on a weighted basis, you wait to receive a bond’s cash flows, and it estimates how much the price changes for a given move in yields: higher duration means larger price swings. Zero-coupon bonds have a duration equal to their maturity, which is why they are among the most volatile bonds when rates move.

Where the rate changes come from: the Fed and the market

When people say the Fed is raising rates, they usually mean the federal funds rate, the target the Federal Open Market Committee (FOMC) sets for overnight lending between banks. Many other short-term rates follow it. A hike pushes up short-term market yields, lowering the prices of existing fixed-rate bonds and raising the rates offered on new ones. A cut does the opposite. A rate hike does not raise the value of bonds you already own. It raises the income available on bonds bought afterward.

The Fed does not directly set long-term rates. Yields on 10-year and 30-year bonds come from supply and demand and reflect investors’ expectations for growth, inflation and future Fed policy, so short and long rates can move differently:

• If investors think the Fed has set rates too low, they expect more inflation later. Long-term yields rise relative to short-term ones, and the yield curve steepens.
• If investors think policy is too tight, long-term yields fall relative to short-term ones, and the curve flattens.

The yield curve plots yields across maturities, usually for Treasuries, and normally slopes upward because investors want extra yield for tying up money longer. A flat or inverted curve, where short-term yields match or exceed long-term ones, is often read as a sign of a possible recession. For a bondholder, the shape matters because a Fed move can hit a 2-year note and a 30-year bond very differently.

Inflation and real returns

Inflation is a bond’s main long-run threat, because a fixed coupon buys less as prices rise. The real return is roughly the nominal yield minus inflation: a bond yielding 4% during 3% inflation earns about 1% in real terms.

When inflation runs high, or investors expect it to rise, they demand higher yields to make up for that loss. Yields rise across the curve and prices fall. Long-term bonds fall the most, since their payments are exposed to inflation for the longest time.

When the answer changes

The inverse rule describes market prices of fixed-rate bonds. Several situations change what it means for a particular investor.

Holding to maturity. A price drop is a loss only if you sell. If you hold a fixed-rate bond to maturity and the issuer doesn’t default, you collect every coupon and the full face value, whatever rates did in between. A zero-coupon bond held to maturity locks in the yield set at purchase. The cost of a rate rise is the higher income you gave up, not lost principal. Before maturity, the drop is an unrealized loss that matters if you need the cash early.

Bond funds. A bond fund holds many bonds and replaces them as they mature, so it never reaches maturity. When rates rise, its share price falls roughly in line with its duration. Over time, the fund reinvests at the new, higher yields.

Floating-rate bonds. When a coupon resets periodically to a benchmark, the payments rise along with rates. The price stays much more stable. The inverse relationship applies with full force only to fixed payments.

Credit risk. The other main bond risk is credit risk, the chance that an issuer misses interest or principal payments. U.S. Treasuries are treated as free of default risk, so their prices respond mainly to rates. Corporate bonds also move with views about the issuer: improving credit can lift a bond’s price even as rates climb, and a riskier issuer’s bond can fall while Treasury yields drop.

Callable bonds. A call feature lets the issuer repay early, which it tends to do when rates fall. Because the bond may be called away at a set price, its upside is limited when rates decline. The full inverse effect shows up mainly on the downside.

FAQs

The Bottom Line

Anyone who owns fixed-rate bonds or bond funds faces price swings when rates change, and longer maturities swing the most. A price drop becomes a real loss only if you sell, since a bond held to maturity without default still pays every coupon and its full face value. Bond funds never mature, so their share prices fall with rising rates while they reinvest at higher yields over time.