The Relationship Between Bonds and Interest Rates

Interest rates and bond prices

When you buy a bond, either directly or through a mutual fund, you're lending money to the bond's issuer, who promises to pay you back the principal (or par value) when the loan is due (the bond's maturity date). In the meantime, the issuer also promises to pay you periodic interest payments to compensate you for the use of your money. The rate at which the issuer pays you — the bond's stated interest rate or coupon rate — is generally fixed at issuance.

An inverse relationship

When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is, how does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of opportunity cost.

Investors look to compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's coupon rate — which is fixed — becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself.

When interest rates go up, bond prices go down

This hypothetical example shows that when interest rates increase, bond prices decrease. In this example, a bond carrying an 8% coupon on a $1,000 bond would sell for $875; while a bond carrying a 7% interest rate on a $1,000 bond would sell for face value; and a bond carrying a 6% interest rate would sell for $1,166.

A hypothetical example: The ABC Company offers a new issue of bonds carrying a 7% coupon on a $1,000 face value and a 10-year maturity. This means it would pay $70 a year in returns. After evaluating various investment alternatives, you decide to purchase the bond at its par value of $1,000.

  • If interest rates go up: Let's suppose that later that year, interest rates in general go up. If new bonds that cost $1,000 are paying an 8% coupon — or $80 a year in interest — buyers will be reluctant to pay the $1,000 face value for your 7% ABC Company bond. In order to sell, you'd have to offer your bond at a lower price — a discount — that would enable it to generate approximately 8% to the new owner. In this case, that would mean a price of about $875.
  • If interest rates fall: If rates dropped to below your original coupon rate of 7%, the bond would be worth more than $1,000. It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market.

Of course, many other factors go into determining the attractiveness of a particular bond, such as the length of time until the bond matures, whether or not its interest is taxable, the creditworthiness of its issuer, the likelihood that the issuer will pay off debt early, and more. Investors should be aware that interest rates vary virtually every day, and the movement of bond prices and bond yields are simply a reaction to that change.

Mutual fund investing involves risks, including the possible loss of principal, and may not be appropriate for all investors. Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds held by the fund. In general, when interest rates rise, bond values fall and investors may lose principal value. Interest rate changes and their impact on the fund and its share price can be sudden and unpredictable. Funds that concentrate their investments in a single industry may face increased risk of price fluctuation over more diversified funds due to adverse developments within that industry. Foreign investments are especially volatile and can rise or fall dramatically due to differences in the political and economic conditions of the host country. These risks are generally intensified in emerging markets. Smaller- and mid-cap stocks tend to be more volatile and less liquid than those of larger companies. High-yield securities have a greater risk of default and tend to be more volatile than higher-rated debt securities. Consult a fund's prospectus for additional information on these and other risks.