Why bond prices fall when interest rates rise

The higher the interest rate—the higher the return. Right?

Well that’s definitely accurate if we’re talking about GICs or savings accounts. However, bond funds and interest rates have an inverse relationship. In fact they thrive on moving in opposite directions.

But why is that?

Before we get into that, you need to first understand two components of a bond: its price and its yield.

In the case of a bond, the yield (the return on your investment) is based on both the purchase price of the bond and the fixed rate of interest payments (or ‘coupons’ as they are referred to).

Whatever the prevailing interest rate happens to be at the time, that rate will set the value of the coupons.

For example:

• Let’s assume you’re an investor that buys a new 5-year bond
• Let’s also assume the price of that bond is $1,000 (face value of the bond at time of purchase) and that the prevailing interest rate (at the time) is 3%
• As long as interest rates remain constant over those 5 years, that bond will provide you with a yield of $30 a year (your annual ‘coupon payments’)

Using our above example—let’s now say interest rates increase by 1% before maturity.

With prevailing interest rates now at 4%, investors will be able to buy new comparable bonds with a higher yield (paying $40 in coupons annually), which doesn’t provide much of an incentive for people to buy the 3% bonds. So in order to compensate, the value of the 3% bonds will fall—selling at a discount.

Here’s what that drop in value could look like:

As you can see from the above example, just a 1% rise in rates (from 3% to 4%) has the potential to drop the value of that bond by 4.5% (from $1,000 to $955).

That’s the amount the original bond price (at 3%) would need to drop in order to offer the same return as the new prevailing rate (4%), over the 5 years until maturity. Naturally any drop in value of your own bond would depend on its price and the prevailing interest rate—both at the start of the term and after any rate increase. However, hopefully this example gives you a better idea of the ‘seesaw’ effect interest rates have on bond funds (I.e. when interest rates go up, bond prices go down / when interest rates go down, bond prices go up).

If you were in the market to buy new bonds AFTER a rate increase—while the 4% bond would obviously bring in the higher yield, there is a benefit to purchasing the 3% bond. You’d be getting it ‘on sale’.

By purchasing the 3% bond at $955 (as the above chart illustrates), you would actually receive its full $1,000 face value at maturity, even though you paid $45 less for it.

While it would only pay out at the old coupon rate of $30 a year (for a total of $150 after the 5-year term, which is $50 less than what the 4% bond would pay out)—in addition to the extra profit of $45, your total return would be 4.3% annualized over 5 years (assuming you were able to reinvest all of the interest payments at the prevailing rate).

Have any questions about the impact of rising interest rates on your bonds? Get in touch with us.

When it comes to bond funds and interest rates, there will always be ups and downs. It’s just a matter of weighing the impact any changes in rates will potentially have on your investment portfolio and timeline. However, before you make any final decisions, be sure to speak with an Educators financial specialist. Having provided financial guidance exclusively to members of the education community for over 40 years, we can help to ensure your investment portfolio is still on track towards meeting your overall goals—no matter where you are in your career, or what your pension income is in retirement.

Have one of our financial specialists contact you about setting up a portfolio review.

Above charts purely for illustration purposes only.