How do bond prices change when interest rates rise?

When interest rates rise, bond prices fall. This inverse relationship exists because newly issued bonds offer higher returns, making existing bonds with lower rates less attractive. As a result, the price of older bonds drops to stay competitive in the market.

Why Bond Prices and Interest Rates Move in Opposite Directions

The key reason bond prices fall when interest rates rise lies in opportunity cost. Investors want better returns, and newly issued bonds will offer higher interest (coupon) when the market rate rises. Hence, existing bonds must lower their prices to remain attractive.

• New bonds offer better yields.
• Existing bondholders must discount prices to compete.
• This results in lower bond prices in the secondary market.

Example of the Interest Rate Effect on Bonds

Imagine you bought a bond that pays 6% interest. If interest rates in the market rise to 7%, your bond becomes less appealing because investors can now get better returns elsewhere. To sell your bond, you’ll need to offer it at a lower price so it yields around 7% to match new offers.

This adjustment in price helps align the returns of older bonds with new ones in the market, creating the inverse price relationship.

How Much Can Bond Prices Drop?

The price change depends on two main factors:

• Duration: Longer-duration bonds are more sensitive to rate changes.
• Coupon rate: Bonds with lower interest rates drop more in value when rates rise.

A 1% rise in interest rates could reduce the price of a 10-year bond significantly more than a 1-year bond. This concept is called interest rate risk.

What Should Investors Do When Rates Rise?

When rates are expected to rise, investors often shift to:

• Short-duration funds: These react less to interest rate changes.
• Floating rate funds: These adjust coupon payments as rates rise.
• Dynamic bond funds: Fund managers actively manage duration based on interest rate outlook.

Actively managing your bond exposure can help reduce losses during rising rate cycles and even create opportunities for future gains.

In simple terms, when interest rates rise, bond prices fall because investors prefer the higher returns from newly issued bonds. The longer your bond's maturity and the lower its coupon rate, the more its price will drop. By choosing the right bond strategy and adjusting your portfolio, you can manage interest rate risks effectively and maintain your returns.