Key Points

The prices of existing bonds rise when interest rates fall, and fall when interest rates rise, all else being equal. Why? Bonds generate fixed income payments. So when market interest rates change, the market value of a bond with a fixed payment will change as well. When interest rates change, the prices of long-term bonds tend to change faster than those of shorter-term bonds—something to remember if you think interest rates are heading up.

One of the most fundamental factors to consider in fixed income investing is interest rates, which present both risks and opportunities—particularly in today’s low-interest-rate environment. This is important whether you invest in fixed income and are concerned about managing risk in your total portfolio, or if you invest in bonds for income and income alone.

Interest rates today are close to the lowest they’ve ever been, in turn dropping yields to historic lows for money market funds and shorter-term bonds and CDs. Despite all the talk about inflation and potentially rising rates, interest rates have remained at depressed levels this year—but we all know that interest rates won’t stay low forever.

Regardless of whether interest rates rise or fall (now or at any time), changes in interest rates mean changes in bond prices. as well. This generally won’t be an issue if you plan to hold your bonds to maturity and don’t need to sell before then (more on this later), but it will impact the value of your bonds on your statements and, more importantly, how much you’ll likely receive if you do need to sell before maturity.

So why do changing interest rates change the prices of bonds?

Bond prices rise and fall when interest rates change

Here’s one way to think about it: When you buy a bond, you’re typically promised a fixed income stream, in the form of regular coupon payments. (For definitions of some of these key terms, please see Definitions below.)

If you purchase one investment with a fixed payment, and then in a month from now buy a different investment promising a higher rate, the first investment you bought wouldn’t be worth as much in comparison, all else being equal.

You’ll still get back the promised par amount when your bond matures (assuming the issuer doesn’t default), but in the meantime, you’ll receive “below” market fixed income payments. You locked in the interest rate on the bond you purchased initially, and now that fixed rate looks less appealing compared to other rates today.

It also works in the other direction. If rates fall and you can’t buy another investment with a coupon payment as high as what you’re already receiving, your older investment would be worth more than any new investments you buy with lower coupon payments. In other words, its value would be expected to rise, compared to currently available comparable alternatives.

Here’s an illustration: 1

Impact of Interest Rates on Bond Investments

Coupon: The interest payment sent to the owner of an individual bond, usually twice a year. The coupon rate is the interest rate the issuer promises to pay to the investor. For most fixed-income investments, this rate is fixed at the time a bond is issued and doesn’t change.

Market interest rates: The prevailing interest rates in the bond markets on any particular day. These rates change based on the economy, Federal Reserve policies and other factors. There is no single market interest rate. The rates will vary based on the time to maturity for a particular bond, the credit quality of the issuer and other factors.

Market price: The current value of an existing bond if you wanted to sell. This is the value you’d see on your quarterly statements, as well as the estimated price you’d receive from a buyer. Market prices can be above (or at a premium to) the par value, or below (at a discount to) the par value, depending on current market interest rates, the promised coupon rate and other conditions.

Maturity: The date that a bond’s par (face) value is repaid and interest payments stop. The longer the time to maturity, generally, the higher the interest rate will be—but the higher the risk of a bond’s price falling, as well, if market interest rates increase. As time passes and the maturity date approaches, the impact of interest rates declines. The price of a bond, if trading at a discount or premium, will move back toward par the closer the maturity date.

Par: Also known as face value, par is the amount an investor originally paid for a bond (assuming it was bought new) that will be returned to the investor when the bond matures. The market price of a bond can change after it’s issued, for the reasons we’ve discussed, but the par value never changes. Usually it’s $1,000 per bond, though there are exceptions.

Yield or Yield-To-Maturity: Yield is the rate of return you could expect to receive on a bond if you buy it today and then hold to maturity. This would include the return from any coupon payments as well as if you bought a bond at a discount or premium and it moves back toward the par face value at maturity. Remember, at maturity, you’re promised the par (or face) amount, and that never changes.

Prices change faster for long-term bonds

Prices also tend to fall faster for longer-term bonds if rates rise, and vice versa, because you’ll live with the fixed coupon payment for a longer period of time for a bond with a longer maturity. There will be more time that you’ll receive a coupon payment that’s either above or below the current market interest rate, and therefore the more or less appealing the bond might be to an investor compared to the comparable alternatives that are currently available.

Let’s look at a hypothetical example: In the chart below, a newly issued 30-year US Treasury bond purchased at the beginning of 2012, at a 3.0% interest rate experienced a 7% price decline during the next six weeks. Over that period, the market interest rate on a 30-year Treasury bond rose to 3.5%.

A new 10-year Treasury bond with a yield of 1.8% when purchased at the beginning of 2012, however, only experienced a 4% price decline. The market interest rate (or yield) on the 10-year Treasury bond over that period increased to 2.3%.

Hypothetical Bond Yields, Returns in a Rising-Rate Environment