Why Bonds Lose Value When Rates Rise

Bonds are often considered “safe” investments.

But they’re not without risk, and one of the main risks you face when investing in bonds is rising interest rates. As rates go up, bonds can lose money. That’s a surprise to a lot of people, so let’s go over how interest rate changes affect bond prices.

Just the Basics

If you just want to know how it works without getting into detail, here are the basics: bond prices generally move opposite of interest rates. In other words, if interest rates go up, bond prices go down. A bond price is of course the amount you can sell your bond for (or your account balance in bonds when you look at your account statement), so it can be shocking to see losses in what you might have considered safe investments.

You know what bond prices are, but what about interest rates? There are a lot of different types of interest rates, but to keep it simple you might just think about interest rates in general.

A photo of bond prices and interest rates playing in the park

Interest Rates and Bond Price Example

To make things more concrete, let’s assume you buy a bond and interest rates rise. Why would the value of your bond go down?

Assume you buy a bond that pays 3% interest for 10 years (or, if you’re not a Rockerfeller, you invest in a mutual fund that buys these bonds). The price of the bond when you buy is $1,000. That means you’ll get $30 per year – that’s 3% of $1,000 – for the next 10 years. You’ll also get your $1,000 back at that point (assuming the bond issuer doesn’t go belly-up, but let’s just assume that’s not going to happen because you’ve found a relatively safe bond and we’re clairvoyant).

Three percent isn’t too shabby– it’s helping you grow your money, and you’re not taking much risk. But what happens if rates rise to 4% after one year?

If you wanted to sell your bond, you’d find that you can’t sell it for the full $1,000 you paid for it. It’s not that the issuer is any less trustworthy, or that bonds depreciate like new cars fresh off the lot. The problem is that your bond is less attractive because of its lower interest rate. This may not matter to you if you don’t intend to sell the bond anytime soon (it’s just a loss on paper), but it can be a problem if you want to get out. It can also be unpleasant to see these losses on your account statements.

Why exactly is the bond worth less? Let’s assume you want to sell it to somebody. You tell them that you’ve got a nice bond paying 3% for the next 9 years or so. But your buyer can buy a brand new 10 year bond that pays 4% – or $40 per year – for the same $1,000. Why would she pay you $1,000 to get $30 when she can pay $1,000 to get $40?

Now, your buyer is not unreasonable, so she proposes a solution: she’ll pay you less than $1,000 for the bond so that she gets more or less 4% – just like she could get anywhere else for a similar level of risk. If the bond lasted forever, the buyer might propose paying you $750 because $30 per year would be 4% of the $750 purchase price. But that’s not quite fair, because the buyer will eventually get the full $1,000 back at maturity (and the gain of $250 would help make up for the smaller interest payments if your buyer has a long-term perspective). So a fair price is somewhere above $750, but it’s certainly less than $1,000. A bond calculator will tell you that your bond is worth about $925.

Managing the Risks

Of course, there are a lot of different types of bonds, and they all respond to interest rate changes differently. But if you focus solely on interest rates (which you can’t do – you have to look at the big picture), then you can manage your risk by using shorter-term bonds and lower-quality bonds.

Shorter-term bonds suffer less because you (or your buyer) are not stuck with the lower interest rate for as long as, say, a 30-year bondholder is: there’s light at the end of the tunnel, and you can reinvest in better paying bonds very soon. How do you know how to find these bonds? You can start by looking for mutual funds that focus on “short-term” or “limited-term” investments – but you have to research the funds to find out what you’re really getting. It’s also a good idea to check out any bond’s (or bond fund’s) duration. This will tell you roughly how much you might expect to lose if rates rise by 1%.

Lower-quality bonds might also hold up to rising interest rates better because sometimes rates rise as the economy improves: if the economy’s improving, it’s possible that the bond issuer is also gaining strength and the bonds are becoming better-quality bonds (maybe not high-quality, but better is better). Of course, now we’re talking about investing in junk bonds and other risky instruments, which might be the exact opposite of what you want for the bond portion of your assets.

For more on that topic, see an article on Reach Financial Independence about keeping “safe” investments safe in case rates rise.

No Free Lunch

Ultimately, you just have to realize that you’re always taking some kind of risk, and you’ll have to decide which ones you’re willing to take. You can try to dump everything into short-term bonds and junk bonds, but then you’ll just be taking different risks. So be mindful of the risks of rising interest rates as you invest, but remember that you can never know if (or how quickly) interest rates will actually rise, nor what the effects will be.

Photo credit:Mykl Roventine