Bond prices change when interest rates change. Here’s why.
by Dana Anspach
Bond prices rise when interest rates fall, and bond prices fall when interest rates rise. Why is this? Think of it like a price war; the price of the bond adjusts to keep the bond competitive in light of current market interest rates. Let’s see how this works.
Why Bond Prices Change When Interest Rates Change
A dollars and cents example offers the best explanation of the relationship between bond prices and interest rates.
Let’s look at a case study.
Case Study Facts
- You buy a bond for $1,000.
- It matures in four years (at which time you get back your $1,000 investment).
- Its coupon rate (interest rate) is 4%, so it pays 4% a year, or $40 a year.
Suppose one year after you purchase the bond interest rates rise to 5% and you decide to sell your bond. When you enter an order to sell, the order goes to the market, and potential buyers now compare your bond to other bonds and offer you a price. This all happens very quickly over the internet.
How does your bond compare to other bonds on the market? Since interest rates went up, a newly issued $1,000 bond which matures in three years (the time left before your bond matures) is paying 5% interest or $50 a year. That means your bond must go through a market value adjustment to be fairly priced when compared to new issues. Let’s take a look at how this market adjustment works.
Market Adjustment to Bond Prices
- If an investor buys your bond for $1,000, they will receive $40 x 3, or $120 in interest over the remaining three years.
- If an investor buys a new bond for $1,000, they will receive $50 x 3, or $150 in interest over the remaining three years.
- There is no incentive to buy your bond at its face value of $1,000 since the investor would receive less interest than the newly issued bonds. Thus the market adjusts the price of your bond to make it equivalent.
- In this set of circumstances, you may receive an offer of about $970 for your bond. (When a bond sells for less than its maturity value it is said to trade at a discount.)
An investor who bought your bond for $970 would now receive the $120 of interest, plus the additional $30 of principal when the bond matures. Because they were able to pay less for the bond, they would receive the same dollar amount of profit, over the same time frame, as if they bought a newly issued bond paying a higher interest rate.
If you hold your bond to maturity, you receive the full $1,000. The current market price of the bond only matters if you are selling your bond now. This makes individual bonds a good choice when you want a certain outcome. You know how much you’ll get and when you’ll get it, and you don’t have to worry about the price fluctuations. For retirement income, individual bonds are frequently used in what is called a bond ladder to create an annual stream of cash flow that is used to live on in retirement.
Bond Prices, Interest Rates, and Duration
There is a formula you can use to estimate the effect a change in interest rates will have on a bond or bond fund. In the white paper, The 4 Percent Rule is Not Safe in a Low-Yield World, authors Michael Finke, Wade Pfau, and David Blanchett state, “One method to approximate the impact of a change in interest rates on the price of bonds is to multiply the bond’s duration by the change in interest rates times negative one.
To use this formula, you must understand and look up a bond’s duration, which in simplistic terms is a weighted average measuring the length of time the bond will pay out. The higher the duration, the more sensitive the bond or bond fund will be to changes in interest rates.
Other Factors that Influence Bond Prices
The example I provided does not account for all factors that affect a bond’s market price. The final price of a bond depends on the credit quality, type of bond, maturity, and frequency of interest payments.
In general, bonds with similar terms will adjust to interest rates in a like manner.
If you own a bond fund, the price of the shares of the fund will reflect the collective pricing on all the bonds owned by the bond fund.
What Type of Bonds Fare Well in a Rising Interest Rate Environment?
There are two types of bonds which may not go down when interest rates rise. Both floating rate bonds funds and inflation-adjusted bond funds may maintain their value in a rising interest rate environment because the interest payments on these types of bonds will adjust.
Also, if you own individual bonds rather than bond funds and plan to hold your bonds to maturity, then you will not need to be concerned about changes in interest rates as you have no plans to sell your bond, so it’s interim price is irrelevant to you.