How bonds work, and why rising interest rates push their prices down
Short answer: a bond is a loan. You lend money to a government or company, it pays you interest, and it returns your principal on a set date. Bond prices move in the opposite direction to interest rates: when rates rise, existing bonds that pay less become worth less, and when rates fall, they become worth more. The longer the bond, the bigger that price swing, which is measured by a number called duration.
How does a bond work?
A bond has a face value (often $1,000), a coupon (the interest rate it pays), and a maturity date. If you buy a 10-year bond with a 3% coupon, you receive $30 a year for ten years, then your $1,000 back, as long as the issuer does not default. If you hold it to maturity, those are your cash flows, whatever happens to the price in between.
Why do bond prices fall when rates rise?
Suppose you own that 3% bond and new 10-year bonds now pay 4%. Nobody will pay full price for your 3% bond when they can buy a 4% one, so its price must fall until its overall return matches the market. Using a standard bond pricing formula:
| 10-year bond, 3% coupon, $1,000 face | Price | Change |
|---|---|---|
| New bonds yield 2% | about $1,089.83 | +9.0% |
| New bonds yield 3% (same as coupon) | $1,000.00 | 0% |
| New bonds yield 4% | about $918.89 | -8.1% |
The price change is only a loss on paper unless you sell. If you hold the bond to maturity, you still get all your coupons and your $1,000 back. That is why a bond held to maturity behaves differently from a bond fund, which never matures and whose price moves all the time.
What is duration?
Duration is a rule-of-thumb measure of how much a bond's price changes for a 1 percentage point change in rates. A duration of 6 means a bond's price falls about 6% if rates rise 1 point, and rises about 6% if they fall 1 point. Longer bonds have higher duration. Compare a 3% coupon bond when rates are at 4%: a 5-year bond is priced near $955, a 10-year near $919, and a 30-year near $827. The longer you lend, the more a rate change hurts.
What are the main types of bonds?
- US Treasury bonds. Backed by the US government, with very low risk of default. Interest is taxed by the federal government but not by state or local governments. TIPS are Treasuries whose principal adjusts with inflation.
- Corporate bonds. Issued by companies. They pay more than Treasuries to compensate for the risk the company may not repay. Investment-grade bonds are safer; high-yield ("junk") bonds pay more and behave more like stocks.
- Municipal bonds. Issued by states and cities. Their interest is generally exempt from federal income tax, which can matter for people in high tax brackets.
- Bond funds and ETFs. Hold hundreds of bonds, so you diversify, but the fund has no maturity date and its price moves with rates.
What risks do bonds carry?
- Interest rate risk. Prices fall when rates rise, more so for long bonds.
- Credit risk. The issuer may not pay. Credit ratings, such as AAA or BB, estimate this risk.
- Inflation risk. Fixed payments buy less if prices rise faster than you expected.
- Reinvestment risk. If rates fall, you may have to reinvest your coupons or matured principal at lower yields.
What role do bonds play in a portfolio?
Bonds mainly add stability and a regular income, and they often (not always) hold up better than stocks in a stock market fall. How much you hold is part of your asset allocation. For short goals under five years, bonds, Treasury bills and savings products are usually more suitable than stocks, which is compared in our guide to high-yield savings, CDs and Treasury bills. When bonds fall in value, remember that rising rates also mean new money earns more, which is why a falling bond price is not purely bad for a long-term holder.
General education, not investment advice. Bond prices and yields change daily, and the examples use simplified assumptions with annual coupons.
Frequently asked questions
What is a bond?
A bond is a loan to a government or company. It pays you regular interest, called the coupon, and returns your original amount, the principal, on a set maturity date.
Why do bond prices fall when interest rates rise?
Because new bonds pay more, so existing bonds with lower rates must sell for less to give buyers the same overall return. In the example above, a 3% bond falls about 8% when market yields rise to 4%.
What is bond duration?
Duration estimates how much a bond's price changes for a 1 percentage point change in interest rates. A duration of 6 means roughly a 6% price move for each 1 point change in rates.
Are Treasury bonds safe?
They have very low risk of default because they are backed by the US government. Their prices can still fall when interest rates rise, and inflation can reduce what their payments can buy.
Is a bond fund the same as owning a bond?
Not quite. A single bond returns your principal at maturity. A bond fund holds many bonds and never matures, so its price keeps moving with interest rates and you cannot be sure of getting your original amount back on a particular date.