Bond Math 101: Why Rising Interest Rates Can Hurt Bond Prices
Bonds are often viewed as the conservative part of a portfolio. But long-dated bonds—and the funds that own them—can experience surprisingly large price declines when interest rates rise.
Fixed income does not mean fixed value.
Bonds are often described as the safer or more predictable portion of an investment portfolio.
That description can create a common misconception: because a bond's interest payment may be fixed, its market value must also be fixed.
It isn't.
When market interest rates rise, the price of an existing fixed-rate bond will generally fall.
And the longer investors must wait to receive the bond's cash flows, the more sensitive its market value can be to changes in interest rates.
Start with a $1,000 bond.
Imagine you purchase a bond for $1,000 that pays 4% interest and matures in 10 years.
Assuming the issuer makes its payments as promised, you would receive the contractual interest payments and the bond's principal at maturity.
Now imagine that shortly after purchasing the bond, market interest rates rise.
A newly issued comparable bond now pays 6%.
If another investor can buy a new $1,000 bond and receive $60 per year, why would that investor pay you $1,000 for a bond that pays only $40?
Generally, they wouldn't.
Instead, the market price of your 4% bond would need to fall enough to make its return more competitive with newly issued bonds.
Higher market interest rates make older, lower-paying fixed-rate bonds less attractive. Their market prices generally fall to compensate.
A bond is really a collection of future cash payments.
At its core, bond pricing asks a simple question:
A bond promises future coupon payments and, assuming the issuer fulfills its obligations, repayment of principal at maturity.
Investors determine today's value of those future payments by comparing them with the return available from similar investments today.
When today's available interest rate rises, future fixed payments become less valuable in comparison.
Why long-term bonds can be hit much harder.
Now imagine two otherwise similar bonds.
Principal is scheduled to be returned relatively soon.
Investors must wait much longer for the bond's principal repayment.
If interest rates rise, the owner of the 2-year bond does not have to wait very long before the bond matures and the money can potentially be reinvested at the new higher rates.
The owner of the 20-year bond may be receiving below-market payments for many more years.
The market therefore generally requires a larger price adjustment for the longer-dated bond.
Duration helps measure interest-rate sensitivity.
Maturity tells you when a bond is scheduled to repay principal.
Duration is different. It helps estimate how sensitive the price of a bond or bond portfolio may be to changes in interest rates.
For example, consider a bond portfolio with a duration of approximately 8.
If interest rates rise by approximately one percentage point, a simplified duration calculation would suggest a price decline of approximately:
Duration is an estimate rather than a guarantee. Actual bond prices can also be affected by yield-curve movements, coupon rates, convexity, embedded options, credit changes, liquidity, and other factors.
What could a 1% increase in rates mean?
The illustration below shows simplified duration-based estimates. Notice how quickly potential price sensitivity increases as duration rises.
Maturity isn't the only factor.
Lower-coupon bonds generally tend to have greater interest-rate sensitivity than otherwise similar higher-coupon bonds.
One way to understand why is to think about when the investor receives the bond's economic value.
A higher-coupon bond returns more cash to the investor along the way. With a very low-coupon bond, a larger portion of the investment's value may depend on payments farther into the future.
Those distant cash flows are particularly sensitive to changes in prevailing interest rates.
“But don't I get my money back at maturity?”
For an individual bond, this is an important distinction.
If you own a bond and hold it until maturity, and the issuer fulfills its obligations, temporary market-price fluctuations do not necessarily determine the amount of principal you receive at maturity.
*Simplified example assuming the bond is held to maturity and the issuer fulfills its principal obligation. Actual bonds may also contain call, conversion, or other provisions.
That does not mean the temporary decline is meaningless.
If you need to sell the bond before maturity, the lower market value can become a realized loss.
There is also an opportunity cost: newer bonds may now offer higher yields than the bond you already own.
Bond ETFs introduce an important structural difference.
Bond ETFs can be useful portfolio tools. They can provide diversification, daily liquidity, easy trading, and access to a large portfolio of bonds through a single investment.
But there is one difference investors should understand:
An individual bond may mature on a specific date.
A traditional bond ETF generally owns a continually changing portfolio of bonds and seeks to maintain a particular investment mandate.
Bonds may mature, be sold, or be replaced with newly purchased bonds. The fund itself generally continues operating.
Defined-maturity bond ETFs are an exception. Those funds are specifically designed to terminate around a stated year.
Individual bond vs. traditional bond ETF
This difference can matter when interest rates rise.
Duration still matters—perhaps more than many investors realize.
Suppose an investor buys a long-duration bond ETF with an effective duration of approximately 15.
Now imagine interest rates rise approximately two percentage points.
This is only a simplified illustration—the actual result would depend on many factors.
But it demonstrates an important point:
“I'll just wait until the bonds mature” doesn't work the same way.
If you own an individual bond, you can identify the date on which that particular bond is scheduled to repay principal.
With most traditional bond ETFs, there is no equivalent maturity date for your ETF shares.
The fund may hold hundreds or thousands of securities, and its portfolio changes over time as it follows its investment objective.
That does not make the ETF inferior.
It means the investor owns a different type of fixed-income exposure.
A specific security progresses toward a defined maturity date.
The portfolio generally maintains exposure to a particular segment of the bond market over time.
Rising rates are not permanently bad for bond investors.
Rising interest rates create two competing effects.
As a bond ETF's portfolio changes, proceeds can be reinvested into securities offering the new, higher prevailing yields.
Over time, that higher income can help offset some or all of the initial price decline.
This is one reason an investor's time horizon matters when evaluating interest-rate risk.
A higher yield may come with considerably more interest-rate risk.
Investment B offers one additional percentage point of hypothetical yield.
But its interest-rate sensitivity could be dramatically greater.
Bond funds can contain several different types of risk.
Interest-Rate Risk
Changes in market interest rates can change the value of existing fixed-rate bonds.
Credit Risk
An issuer's ability to make interest and principal payments can deteriorate.
Credit-Spread Risk
Corporate bonds can fall when investors demand additional compensation for bearing credit risk, even if Treasury rates do not rise.
Call Risk
Some bonds may be redeemed by their issuers before their stated maturity.
Liquidity Risk
Some underlying bonds can become more difficult or expensive to trade during periods of market stress.
Reinvestment Risk
Cash flows may eventually have to be reinvested at lower rates if market yields decline.
A maturity schedule can be designed around future needs.
One potential advantage of individual bonds is the ability to construct a portfolio around specific maturity dates.
For example, an investor might build a bond ladder:
As each bond matures, the investor can decide whether to use the money or reinvest it at prevailing rates.
Traditional bond ETFs instead provide ongoing exposure to a portfolio of bonds.
Neither structure is automatically superior.
Look beyond the yield.
How sensitive may the portfolio be to changes in interest rates?
How long until the underlying securities mature?
Who owes the money, and how strong are those issuers?
What level of income is currently embedded in the portfolio?
What does the fund charge for managing the portfolio?
Does the fund own Treasuries, corporate bonds, municipal bonds, mortgages, high-yield debt, or something else?
Understand the math behind the label.
Stocks are generally understood to fluctuate.
Bonds often receive a different psychological treatment.
A bond's contractual payments may be fixed. Its market value is not.
When interest rates rise, existing fixed-rate bond prices generally decline. The farther into the future those cash flows extend, the larger the potential effect can be.
For an individual bond, holding to maturity can provide a defined endpoint, assuming the issuer fulfills its obligations and subject to the bond's terms.
For most traditional bond ETFs, there is no comparable maturity date for the fund itself.
Understanding duration, yield, maturity, credit quality, and fund structure can help investors determine how conservative a fixed-income investment really is.
Your bond allocation deserves the same scrutiny as your stock allocation.
Investors often spend considerable time evaluating risk in their stocks while treating the fixed-income side of a portfolio as inherently safe.
PortfolioLab evaluates bonds and bond funds based on the role they are intended to serve within the overall portfolio—not simply because they fall under the label of fixed income.
This material is provided for educational and informational purposes only and should not be construed as individualized investment, tax, or legal advice or as a recommendation to purchase or sell any security.
Examples involving bond prices, interest rates, duration, yields, and hypothetical price movements are simplified illustrations intended to explain general fixed-income concepts. Actual bond and bond-fund performance can differ materially due to changes in interest rates, yield curves, credit quality, liquidity, embedded options, portfolio composition, market conditions, expenses, and other factors.
Bonds and bond funds involve investment risk, including possible loss of principal. Holding an individual bond until maturity does not eliminate credit risk, default risk, call risk, or other risks associated with the particular security.