Why Bond Prices Move Opposite to Interest Rates

Imagine you bought a bond last month for $1,000. It promises to pay you $40 every year for ten years and then return your $1,000 at the end. A week later, your neighbor walks into the same brokerage and finds that newly issued bonds, identical in every other way, now pay $50 a year instead of $40. If your neighbor can buy a fresh bond paying $50, what would she pay you for your old one paying only $40? Certainly not $1,000. She would offer less — enough less that the smaller annual payments, spread over the remaining years, work out to the same overall return she could get from the new bond. Your bond's price has dropped, not because anything about your bond changed, but because the world around it did.

This is the central mechanic of the fixed income market. A bond is a contract for fixed cash flows: a stated coupon, paid on a stated schedule, plus the return of principal (the original loan amount) at maturity. Once issued, those numbers do not change. What changes is the prevailing interest rate — the rate at which new borrowers can issue new bonds. When prevailing rates rise, every existing bond with a lower coupon becomes less attractive by comparison. The only way the market can rebalance is for the price of those older bonds to fall until their effective return — their yield — matches what new bonds offer.

The yield is the key concept. A bond's coupon is fixed in dollars, but its yield is the return an investor actually earns given the price paid. If a bond paying $40 a year is bought for $1,000, the yield is 4%. If the same bond is bought for $800, the yield rises above 5%, because the buyer is collecting the same $40 against a smaller outlay and will also receive the full $1,000 face value at maturity. Price and yield are two sides of the same coin: when one moves up, the other moves down. This is not an empirical regularity that might fail next Tuesday. It is an arithmetic identity built into how bonds are priced.

The size of the price move depends on how long the bond has left to run. A bond maturing in one year is barely affected by a rate change, because the investor will get the principal back soon and can reinvest at the new rate. A bond maturing in thirty years is hit much harder: the buyer is locked into the old, lower coupon for decades, and the present value of those distant payments shrinks substantially when discounted at a higher rate. The sensitivity of a bond's price to interest rate changes is called its duration, and longer-dated bonds have more of it.

This inverse relationship explains a great deal of behavior that puzzles new investors. When central banks raise rates to fight inflation, the prices of existing bonds fall, and bond funds — even those holding only safe government debt — can post losses. The bonds inside the fund have not defaulted; their issuers are still paying every coupon on time. What has happened is that newer bonds offer better terms, so the older ones are worth less on the secondary market. An investor who holds a single bond to maturity will still receive every promised payment and the full principal, regardless of what happened to its market price along the way. An investor who needs to sell early, or who marks a portfolio to market, feels the move directly.

The relationship also runs in reverse. When prevailing rates fall, older bonds locked in at higher coupons become more valuable, and their prices rise. This is why bonds issued during high-rate periods can become prized holdings when rates later decline. The cash flows did not change. The world around them did, and the price adjusted to reflect it.