Why Bond Prices Fall When Interest Rates Rise

The first time I saw the bond portion of my retirement account go down, I assumed something had broken. Stocks fall, that I had been warned about. Bonds were supposed to be the part that sat still.

Bonds do not sit still, and the reason they move is a single piece of arithmetic that nobody bothered to show me.

You are making a loan

Buying a bond means lending money to a government or a company. In exchange, three things are written down and fixed: how much you lent, what they pay you each year, and the date they give the original amount back.

Lend $1,000 to the US Treasury for ten years at a 4% coupon and the terms are these.

You hand over $1,000. They pay you $40 a year for ten years. At the end of the tenth year they hand back the $1,000 and it is over.

The $40 never changes. That is the part that matters.

Why the price moves

Suppose a year later the government starts issuing new ten year bonds paying 5%, so a new $1,000 loan pays $50 a year. Now try to sell your old bond, the one that pays $40.

Nobody pays $1,000 for $40 a year when $1,000 buys $50 a year across the street. So the price of your bond falls until the buyer's return matches what they could get elsewhere. Pay $800 for a bond paying $40 a year and the yield is $40 divided by $800, which is 5%.

That is the whole seesaw. The payment is fixed, so the only thing that can adjust is the price.

It works the other way with equal force. If new bonds start paying 2%, your 4% bond is suddenly generous, and buyers bid the price up above $1,000 until the return on offer comes back into line.

Why the long ones move more

Look at the two lines where yields hit 8%. The ten year bond is worth $732 and the three year bond is worth $897, and they pay exactly the same $40 a year.

The difference is how long you are stuck. With three years left you are accepting a below-market payment for three more years and then you get your $1,000 back and can reinvest at the new higher rate. With ten years left you are stuck accepting it for ten, so the discount a buyer demands is much deeper.

That is why a fund holding thirty year government bonds can fall as hard in a year as a stock fund, while a fund holding bonds maturing in two years barely twitches. Same issuer, same credit quality, entirely different ride.

Who you are lending to

Everything above assumes you get paid back. Whether that assumption holds is the other half of what a bond is worth.

US Treasury debt is the reference point, the thing everything else is priced against. A company borrowing for the same ten years has to pay more, because there is some chance it does not pay at all, and the extra yield is called a spread. If the ten year Treasury yields 4% and a company's ten year bond yields 6%, the spread is two percentage points, which on a $1,000 bond is $20 a year for accepting the risk.

Municipal bonds are a third category, issued by states and cities, and their interest is generally exempt from federal income tax. That exemption means a muni paying 3% can beat a taxable bond paying 4% for someone in a high enough bracket, which is why the comparison is always after tax and never on the headline yield.

The thing that rescues an individual bond

If you hold your $1,000 bond to maturity and the issuer pays, you get $1,000 back regardless of what the price did in between. The $800 quote in year three was what someone would have paid you to take it off your hands, not a loss you took.

A bond fund is different, because it holds hundreds of bonds with rolling maturities and never arrives at a single date where everything pays off at par. It sells and reinvests continuously, so the value of your holding is the market value of the pile, marked every day.

The offsetting point is that a fund reinvesting at higher rates is buying better loans. A rate rise hurts the price today and improves the income stream from then on, which is why the damage from a bad bond year tends to repair itself over a period roughly as long as the average maturity of what the fund holds.

Why you own any of this

Bonds sit in a portfolio to do a specific job, and the job is not making money. It is being the part you can spend in a year when the stock part is down 30% and selling it would be the worst available move.

Short and intermediate government bonds do that job, because their price swings are small. Long bonds and the riskier end of company debt do it much less well, since they have a habit of falling at the same time stocks fall, which is precisely the wrong week to find that out.

So if you hold bonds for stability rather than for income, the higher-paying options are usually the wrong ones. The extra yield is compensation for the risk of behaving like a stock.

Find your own number

Most people reading this own bonds through a target date fund, which is a single fund that holds stocks and bonds and shifts gradually toward bonds as the date in its name approaches. It does that shifting whether or not you ever open it.

Go look up your target date fund and find the asset allocation section. It will tell you what percentage is in bonds. On a $150,000 balance, a 30% bond allocation is $45,000 lent out at fixed rates.

Then find the average maturity of that bond portion, which the fund also publishes. That single number tells you roughly how much of a jolt a rate move will give you, and whether the quiet part of your account is as quiet as you assumed.