Why Bond Prices Fall When Interest Rates Rise

Start with the payment the bond promises

A bond’s face value is the amount scheduled to be repaid at maturity, subject to the issuer meeting its obligations. The coupon describes its interest payment. For a simple $1,000 face-value bond with a 3% annual coupon, the annual payment is $30.

If comparable yields rise, that existing $30 payment does not become larger. A buyer can instead demand a lower purchase price so the combination of interest and eventual repayment provides a competitive return.

Sources: Investor.gov: Interest rates and fixed-rate bond prices

Price one remaining payment

Assume exactly one year remains, with $1,030 paid at maturity: $1,000 principal plus $30 interest. Ignore default risk, taxes, fees, and accrued interest. At a required annual return of 5%, the price is $1,030 divided by 1.05, or about $980.95.

At a 3% required return, the price is $1,000. At 1%, it is about $1,019.80. The future payment is the same in all three examples; the price changes to reflect the return a new buyer requires. Real bonds can have many payment dates and additional risks.

Consider when you might need to sell

Holding an individual bond to maturity can make interim price changes less relevant to the planned cash payment, provided the issuer pays as promised. It does not eliminate default risk, inflation risk, or the possibility that you need the money earlier.

If you sell before maturity, the price available at that time matters. Transaction costs and the ability to find a buyer matter too. Bonds with longer remaining maturities generally have greater sensitivity to interest-rate changes than otherwise comparable shorter bonds.

Sources: Investor.gov: Selling bonds before maturity · Investor.gov: Interest rates and fixed-rate bond prices

Do not apply one bond’s maturity date to a whole fund

A conventional bond fund owns a changing portfolio. Your fund shares generally do not come with a promise to repay your original purchase amount on one fixed maturity date. Its share value reflects the bonds and the market.

Read the fund’s interest-rate sensitivity, credit quality, fees, and investment objective. Specialized target-maturity funds have additional features to examine. A label such as “bond fund” does not by itself tell you whether the risk fits money you will need soon.

1. Identify the coupon and remaining maturity.
2. Distinguish credit risk from interest-rate risk.
3. Consider an early-sale scenario.
4. Read a fund’s portfolio and risk disclosures separately.

Sources: Investor.gov: Bond funds and income funds