When market interest rates rise, prices of existing fixed-rate bonds generally fall; when those prices fall, their yields to a new buyer generally rise. The reason is that the bond’s promised coupon and face value are set by its terms, while its market price changes. A lower price makes the same scheduled payments a higher return relative to what a buyer pays, assuming other factors stay the same.
Why do bond prices and yields move in opposite directions?
A fixed-rate bond promises specific payments: periodic coupon interest and, if the issuer meets its obligation, repayment of face value at maturity. Those contractual amounts do not change just because market rates move. The price investors will pay for the bond, however, can change every day.
If newly issued bonds with comparable risk and maturity offer higher rates, an older bond with a lower coupon is less attractive at its original price. Its market price generally has to fall until its fixed payments offer a competitive return to a new buyer. At that reduced purchase price, the bond’s yield is higher. If comparable market rates fall, the older bond’s fixed coupon becomes relatively attractive, so its price may rise and its yield to a new buyer falls. The SEC describes this general pattern as interest-rate risk.
Market rates, bond prices, and bond yields are related but distinct: the market rate is the return available on comparable investments; the bond price is what a buyer pays; and yield measures return in relation to price and cash flows. The inverse relationship is a general rule for fixed-rate bonds, not a guarantee that rates alone explain every price move.
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How coupon, price, and yield differ
- Coupon rate: The stated interest rate applied to the bond’s face value. A fixed-rate bond’s coupon payments generally remain the same as market rates change.
- Market price: The amount a buyer pays for the bond. It can be above or below face value and may change with market yields, time to maturity, credit quality, and other factors.
- Current yield: Annual coupon interest divided by the current market price. Investor.gov’s example is an $80 annual coupon on a $1,000 market price, or an 8% current yield. This measure does not account for all cash flows through maturity.
- Yield to maturity: A widely used estimate of return if the bond is held to maturity, taking account of purchase price and the timing of payments. It depends on assumptions and is not a guaranteed outcome if circumstances change.
A bond trading above face value is at a premium; one trading below face value is at a discount. A bond’s coupon being higher than current market rates can help explain why buyers may pay a premium. For definitions and distinctions, see Investor.gov’s explanation of corporate bonds and its current-yield glossary entry.
What happens to bond prices when interest rates rise?
For a concrete illustration, the SEC’s June 26, 2013 Investor Bulletin shows a 10-year Treasury bond with a 3% coupon and $1,000 face value. After market rates fall from 3% to 2%, the example bond, with nine years remaining, is priced at $1,082 and has a 2% yield to maturity. In the opposite example, after rates rise from 3% to 4%, the same stated coupon bond, also with nine years remaining, is priced at $925 and has a 4% yield to maturity. These are illustrations, not a formula for how much every bond price changes after a one-point rate move. See the SEC Investor Bulletin on interest-rate risk.
Which bonds are more sensitive to rate changes?
Rate sensitivity depends on the bond’s cash flows and terms. When comparing bonds, compare similar credit quality and consider maturity, coupon, duration, and features that can change payment timing.
- Maturity: Longer-maturity bonds generally have more interest-rate risk than otherwise comparable shorter-maturity bonds. More of their value depends on payments farther in the future.
- Coupon: Among otherwise similar bonds, a lower coupon generally means greater sensitivity to rate changes.
- Duration: Duration estimates how sensitive a bond’s price is to interest-rate changes. It is an approximation, not a promise or a complete measure of risk. FINRA explains duration and its limits in its article on duration and interest-rate hikes.
- Embedded options and prepayment: Callable bonds and mortgage-backed securities may not respond in a simple, symmetrical way. For mortgage-backed securities, falling rates can encourage refinancing and early repayment, changing the timing of expected cash flows.
Does a price decline mean you have to sell at a loss?
No. A lower market price is a change in what the bond could sell for now; it is not automatically a realized loss for an investor who holds the bond to maturity and receives the promised payments. That outcome remains subject to the bond’s terms and the issuer’s ability to pay. Someone who sells before maturity receives the prevailing market price, which may be less or more than the purchase price. U.S. government backing does not guarantee a bond’s market price if it is sold early, as the SEC notes in its Investor Bulletin.
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Why a bond’s price can move for reasons beyond rates
The inverse relationship isolates one influence: changing market rates, with other relevant conditions unchanged. In practice, a bond’s price can also respond to changes in the issuer’s credit quality, default risk, liquidity, inflation expectations, call provisions, or prepayment behavior. A floating-rate bond periodically resets its coupon, so its behavior differs from that of a fixed-rate bond. For corporate bonds, the possibility that the issuer will not make promised payments is a separate risk from interest-rate risk; see Investor.gov’s corporate-bond overview.
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