Bond Basics: Why Bond Prices Fall When Rates Rise, and What Duration Tells You

Bonds have a reputation as the safe part of a portfolio, and for good reason: high-quality bonds usually swing far less than stocks. But people are often surprised when a bond fund loses money in a year when interest rates rise. That isn't a malfunction. It's how bonds work.

This guide explains the relationship between bond prices and interest rates, why longer bonds move more, and how a single number, duration, summarizes that sensitivity.

The short version

• A bond pays fixed interest (the coupon) and returns its face value (par) at maturity.
• When market interest rates rise, existing bonds with lower coupons become less attractive, so their prices fall. When rates fall, prices rise.
• Longer-maturity bonds are more sensitive to rate changes than shorter ones.
• Duration estimates how much a bond's price will change for a 1-point change in rates. A duration of 8 means roughly an 8% price change.
• If you hold an individual bond to maturity and the issuer pays as promised, you receive par regardless of interim price swings. Bond funds don't mature, so their prices fluctuate continuously.

How a bond works

A hypothetical bond with:

• Par value: $1,000
• Coupon: 4% a year, so $40 annually
• Maturity: 10 years

You receive $40 each year for 10 years, then your $1,000 back. If you buy it for $1,000 and hold it, you earn 4% a year, assuming the issuer doesn't default.

Why prices move opposite to rates

Suppose that a year from now, new 10-year bonds of similar quality pay 5%. Nobody will pay $1,000 for your 4% bond when they could buy a new one paying 5%. For your bond to sell, its price must fall until its total return, coupons plus the gain from buying below par, matches what new bonds offer.

A bond's price equals the present value of its future payments, discounted at the current market yield:

Running that formula for our 4% coupon bond at different market yields, and repeating it for 2-year and 30-year bonds with the same 4% coupon (annual payments):

A 1-point rise in yields cuts the 2-year bond's price by about 1.9%, the 10-year by about 7.7%, and the 30-year by about 15.4%. That's the core of interest rate risk: the longer you lock in a fixed payment, the more its value changes when rates move.

Notice also that gains when rates fall are larger than losses when rates rise by the same amount. That curvature is called convexity, and it's more pronounced for longer bonds.

Duration: one number for rate sensitivity

Duration measures the weighted average time until you receive a bond's cash flows. In practice, it's used as a sensitivity gauge: modified duration approximates the percentage price change for a 1-point change in yield.

For our 10-year, 4% coupon bond at a 4% yield:

The estimate is close but not exact, because the price-yield relationship curves. Duration works best for small rate changes.

What affects duration:

• Longer maturity → higher duration.
• Lower coupon → higher duration, because more of the value comes from the final payment. A zero-coupon bond's duration equals its maturity.
• Higher yields → slightly lower duration.

Bond funds publish an average duration, which is the quickest way to judge how much a fund's price might move when rates change.

Holding to maturity vs. holding a fund

Individual bonds. If you buy a bond and hold it until maturity, price swings along the way don't change what you receive, as long as the issuer pays. You collect the coupons and get par back. You can lock in a known return, though you face reinvestment and inflation risk.

Bond funds. A fund holds many bonds and continually buys and sells to keep its target maturity. It never matures as a whole, so its price reflects current rates. When rates rise, the fund's price falls, but it gradually reinvests at the new, higher yields. Over a period roughly equal to its duration, higher reinvestment income tends to offset the initial price drop, though this is an approximation, not a guarantee.

Other bond risks

Credit risk. The issuer might fail to pay. Treasury securities are backed by the U.S. government. Corporate and municipal bonds carry varying degrees of credit risk, reflected in ratings and in higher yields for lower quality.

Inflation risk. Fixed payments lose purchasing power when inflation is high. Inflation-protected Treasury securities address this by adjusting principal with inflation. See our article on inflation and real returns.

Call risk. Some bonds can be redeemed early by the issuer, typically when rates fall, which limits your upside.

Liquidity risk. Some bonds are hard to sell quickly at a fair price.

Yield terms you'll see

• Coupon rate: the fixed annual interest as a percentage of par.
• Current yield: annual coupon divided by current price.
• Yield to maturity: the total annual return if you buy at today's price and hold to maturity, assuming all payments are made and reinvested at that rate.
• SEC yield: a standardized yield measure that U.S. bond funds report, useful for comparing funds.

The takeaway

Bond prices move opposite to interest rates, and longer bonds move more. Duration translates that sensitivity into a single number: roughly the percentage price change for a 1-point rate move. If you hold an individual bond to maturity, interim price changes don't affect what you're paid. If you hold a fund, they do, at least until higher yields work their way through.