Why Bond Prices Fall When Rates Rise: Yield, Duration and Credit Risk

Bonds have a reputation as the calm half of a portfolio. Then a year arrives when interest rates rise quickly, and investors discover that bond funds can post losses that look more like a stock market correction. Nothing broke. That is how bonds are built. Once you understand the seesaw between prices and yields, the behavior is predictable, and so are the tools for managing it.

The seesaw

A typical bond pays a fixed coupon and returns its face value (usually $1,000) at maturity. Imagine a 10-year bond paying 4% a year, or $40, issued when 4% was the going rate.

Now suppose market rates for similar bonds rise to 5%. A new bond pays $50 a year. Nobody will pay full price for your $40 bond when $50 bonds are available, so its price must fall until its total return to a new buyer roughly matches 5%. If rates fall to 3%, the opposite happens: your $40 coupon looks generous and buyers pay more than face value.

Using standard bond math, with interest paid twice a year, here is roughly what that 4% bond would be worth per $1,000 of face value if market yields moved immediately after issue:

Two lessons are visible in the table. Price and yield always move in opposite directions. And the longer the bond, the larger the move.

Duration: the sensitivity gauge

Duration turns that second lesson into a single number. Measured in years, it summarizes how sensitive a bond's price is to a change in interest rates. A useful rule of thumb:

Approximate price change ≈ − duration × change in yield

A bond fund with a duration of 6 would be expected to lose about 6% if rates rose by one percentage point, and gain about 6% if they fell by one point. Every bond fund publishes its duration on its fact sheet, and it is one of the most useful numbers there.

Duration is longer when:

• Maturity is longer, because more of the payments are far in the future.
• Coupons are lower, because less of the money comes back early. A zero-coupon bond's duration equals its maturity.

The rule of thumb is an approximation. For large rate moves, a property called convexity means actual price changes differ somewhat from the estimate.

Yield measures

Several "yields" appear on bond quotes and fund pages:

• Coupon rate: the fixed annual interest as a percentage of face value.
• Current yield: annual coupon divided by today's price.
• Yield to maturity (YTM): the total annualized return if bought at today's price and held to maturity, including coupons and any gain or loss to face value.
• Yield to worst: for callable bonds, the lowest yield you could receive if the issuer redeems early.
• SEC 30-day yield: a standardized figure bond funds must report, useful for comparing funds with each other.

Credit risk and spreads

Treasuries carry essentially no default risk. Other issuers do, so they must pay more. The extra yield over a comparable Treasury is called the credit spread.

Independent rating agencies grade issuers:

• Investment grade: higher-rated issuers judged more likely to repay.
• High yield (or "junk"): lower-rated issuers that pay more to compensate for higher default risk.

Spreads move with the economy. When investors worry about a recession, spreads on lower-rated bonds tend to widen and their prices fall, even if Treasury yields are falling at the same time. That is why high-yield bonds often behave more like stocks in a downturn than like Treasuries.

Types of US bonds at a glance

For municipal bonds, the Municipal Securities Rulemaking Board's free EMMA site publishes official disclosures and trade prices.

Call risk

Many corporate and municipal bonds are callable: the issuer can repay early, usually after a set date. Issuers tend to call bonds when rates have fallen, which is exactly when investors would like to keep a higher coupon. Callable bonds pay a little more yield to compensate.

Inflation and real yields

A bond's stated yield is a nominal yield. What matters for purchasing power is the real yield: roughly the nominal yield minus inflation. A 5% bond during a period of 6% inflation loses purchasing power; the same bond during 2% inflation earns a solid real return.

Inflation also explains much of why yields move in the first place. When investors expect higher inflation, they demand higher yields to compensate, which pushes prices of existing bonds down. The gap between a regular Treasury yield and a TIPS yield of the same maturity, called the breakeven inflation rate, shows roughly what inflation the market is pricing in. Watching it alongside nominal yields helps separate inflation worries from changes in growth expectations or Fed policy.

Individual bonds versus bond funds

The two behave differently when rates rise:

• An individual bond has a maturity date. Barring default, you get face value back on that date, so a temporary price drop disappears if you hold.
• A bond fund has no maturity. It continually sells older bonds and buys new ones to maintain a target duration. Its price can stay lower after a rate rise, but it also starts reinvesting at the higher yields, which gradually lifts its income.

A rough guide: after a rate increase, a bond fund held for about as long as its duration has historically tended to recover much of the price decline through higher income, though this is not guaranteed and depends on what rates do next.

Funds offer diversification across many issuers, easy reinvestment and daily liquidity. Individual bonds offer a defined maturity and certainty of cash flows, but building a diversified portfolio of corporate or municipal bonds requires more money and attention, and trading costs for small orders can be high.

Reading a bond fund fact sheet

The four numbers that tell you most about how a bond fund will behave:

1. Duration: how much it should move for a given change in rates.
2. Average credit quality: how much default risk it carries.
3. SEC 30-day yield: a standardized view of what it currently earns.
4. Expense ratio: what you give up every year.

With those four, you can usually predict whether a fund will act like a shock absorber or an amplifier when markets get rough, and choose accordingly.

This article is for education only and is not investment advice.