Why Bond Prices Fall When Interest Rates Rise

Imagine you’ve made a deal. Let’s say you lent a friend $1,000, and they promised to pay you back with a fixed interest rate of 5% per year for the next ten years. This, in essence, is similar to what happens when you buy a fixed-rate bond. You are lending money to an entity, like a company or government, and they are promising to pay you back the original amount, plus a fixed interest rate, over a specific period. This fixed interest rate is determined when the bond is initially issued and remains constant throughout the bond’s life.

Now, let’s say after you made this agreement with your friend, the general interest rates in the market suddenly go up. Perhaps banks are now offering savings accounts with 7% interest, or new loans are being issued at 8%. Suddenly, your initial agreement of 5% doesn’t look quite as appealing, does it? Your friend is still obligated to pay you 5%, which is the agreed-upon rate, but if you were to lend money out today, you could get a better return elsewhere.

The same principle applies to bonds in the market. When market interest rates rise, newly issued bonds will naturally offer these higher, more attractive interest rates to entice investors. Think of it like this: if you are a new investor looking to buy a bond, would you rather buy a newly issued bond paying 7% interest, or an older bond, issued years ago, that is still paying only 5% interest? Most likely, you would prefer the bond with the higher return, the 7% bond.

Because of this preference, the older bond paying the lower 5% interest becomes less desirable in the market. Investors are less willing to pay the original price for a bond that offers a less competitive interest rate compared to what is currently available. To sell this older, less attractive bond, the seller would likely need to lower its price to make it more appealing to potential buyers.

This is the core reason why the price of a fixed-rate bond generally falls when market interest rates rise. The bond’s fixed interest payments, which were attractive when initially issued, become less so when compared to the higher interest rates available on newer investments. To compensate for this lower relative interest rate, the bond’s price must decrease. This price decrease effectively increases the bond’s yield, meaning the total return an investor can expect if they buy the bond at the discounted price and hold it until maturity.

Think of it like a coupon for a discount at a store. If you have a coupon for 10% off, it’s great. But if the store starts offering a general sale of 20% off everything, your 10% coupon suddenly becomes less valuable. To make your 10% coupon attractive again, you might need to offer something extra, or simply accept that its value has diminished in comparison to the new, better deal available. Similarly, a fixed-rate bond paying a lower interest rate in a higher-rate environment becomes less valuable, and its price adjusts downwards to reflect this new reality. This price adjustment allows the bond to remain competitive and attractive to investors in the changing market conditions.