Why do bond prices fall when interest rates rise?

Why do bond prices and interest rates move in opposite directions?#

The SEC calls this a fundamental principle of bond investing: market interest rates and bond prices generally move in opposite directions, and when market rates rise, prices of fixed-rate bonds fall^[1]. The reason is competition between old bonds and new ones.

Imagine you own a bond that pays a 3% coupon. Then market rates rise and newly issued bonds pay 4%. Nobody will pay full price for your 3% bond when a 4% bond is on offer. As the SEC puts it, your 3% bond would be competing with new Treasury bonds that offer a 4% coupon, so its price may be more likely to fall^[1].

A St. Louis Fed explainer describes the same mechanism from the buyer's side: for someone to take the bond off your hands, the reduction in its price offsets the higher interest rates available on newly issued bonds^[2]. The bond's coupon does not change, so its price is the only thing that can adjust.

What does the SEC's own example show?#

The SEC's investor bulletin on interest rate risk uses a $1,000 bond with a 3% coupon paid twice a year and a 10-year maturity, bought when market rates are also 3%^[1]. One year later the bond has nine years left. If market rates have fallen to 2%, its price is $1,082; if they have risen to 4%, its price is $925^[1]. We rebuilt both numbers in code to show where they come from.

Look at the 4% row from a buyer's point of view. A new $1,000 bond would pay $40 a year. Your bond pays $30. The buyer pays about $75 less up front, and that discount is gradually earned back as the bond's price returns to $1,000 at maturity. At $925, the buyer's total return works out to the same 4% a new bond offers — the SEC's table lists the bond's yield to maturity as 4%^[1]. For more on yields, see bond yield explained.

Why do long-term bonds move more than short-term bonds?#

A one-percentage-point move does not hit every bond equally. The SEC notes that the longer a bond's maturity, the greater the risk that its value is affected by changing interest rates before maturity^[1]. A short bond will soon repay its face value, so a below-market coupon only matters for a short time. A long bond locks in that coupon for decades.

Notice also that the gains when rates fall are a little larger than the losses when rates rise by the same amount. That asymmetry is small for short bonds and grows with maturity.

What is duration, and how do you use it?#

FINRA defines bond duration as a measure of how much a bond investment is likely to change in value if interest rates rise or fall^[3]. It is not the same as maturity, which is simply the date the issuer must repay the principal in full^[3].

FINRA's rule of thumb: for every one-percentage-point change in rates, a bond's price moves in the opposite direction by roughly its duration number in percent. A bond with a duration of 10 would be expected to fall about 10% if rates rose by one point^[3]. In general, a higher coupon means a lower duration and a longer maturity means a higher duration^[3].

FINRA suggests looking up a bond fund's duration on its fact sheet, and warns that a low duration does not by itself mean an investment is low risk^[3]. Credit risk, for example, is a separate question — see bond credit ratings explained.

Does any of this matter if you hold the bond to maturity?#

Less than you might think. The SEC notes that if you intend to hold a bond to maturity, day-to-day price changes may matter less to you: the price may move, but you are still paid the stated interest and the face value at maturity^[1]. FINRA makes the same point for buy-and-hold investors^[3]. In the SEC example, holding the 3% bond for all ten years returns $300 of coupons plus $1,000 of principal either way.

Two caveats. First, the promise depends on the issuer paying — the what is a bond page covers credit risk. Second, a below-market coupon still has a cost: you are earning 3% while new bonds pay 4%. That cost is real even if no loss shows on a statement.

Bond funds work differently. A fund's value moves with the prices of the bonds it holds and with its adviser's buying and selling, which is why FINRA's guidance to brokers says bond fund customers should be aware that return of principal is not guaranteed^[4]. Compare the two approaches in bond funds vs individual bonds.

What happens to bond prices when rates fall?#

The same logic runs in reverse. When interest rates fall, existing bonds increase in market value^[2], because their older, higher coupons now look attractive. The St. Louis Fed gives a real example of how much new-issue coupons can change: a 5-year Treasury note bought in May 2020 carried a 0.34% coupon, while one bought three years later carried 3.58%^[2]. By the logic above, an owner of the 0.34% note who wanted to sell would have had to accept a price low enough to compete with the newer, higher coupons.

To see how the Federal Reserve's own rate decisions work, read how the Fed sets interest rates. Whatever moves market rates, the bond-price rule is the same: rates up, prices of existing fixed-rate bonds down; rates down, prices up.

What mistakes do beginners make?#

1. Assuming a government bond cannot lose value

   The SEC says interest rate risk applies to all bonds, even U.S. Treasury bonds^[1]. A Treasury held to maturity repays its face value, but its price can fall in between.

2. Ignoring maturity when rates are uncertain

   A 30-year bond can move many times more than a 2-year bond for the same rate change. Match the bond's maturity to when you will need the money.

3. Confusing duration with maturity

   Maturity is a date; duration is a sensitivity measure. Two bonds with the same maturity can have different durations if their coupons differ.

4. Reading a price drop as a default

   A lower market price after a rate rise does not mean the issuer is in trouble. Check the credit rating and news before drawing that conclusion.