What Happens to Bonds When Interest Rates Rise?

Rising interest rates, or the expectation of a rise, create anxiety throughout the vast international bond market. Rising rates inevitably push bond prices lower and yields higher in that market. But looking at it another way, growing interest rates have no effect on bonds at all.

New Bonds

A bond is a loan from the buyer to the corporation or government that issues the bond. The issuer agrees to pay a specific amount of interest until a certain date, called the date of maturity. For example, a five-year bond pays an agreed-on amount of interest for five years. When the bond matures, the issuer pays the bondholder the original face value of the bond.

That means a five-year bond with an original face value of $10,000 that pays 10 percent interest a year pays the holder of the bond $1,000 (10 percent of $10,000) a year until the bond matures in five years, when the issuer pays back the owner of the bond his original $10,000. The interest rate on the bond is also called the yield.

These terms for a new bond remain the same no matter who the issuer is, how long the maturity is, who owns the bond, or how much the face value of the bond is worth. The terms for new bonds are also unchanged by any rise in interest rates in the general economy after the bond was sold.

Tips

  • New corporate and government bonds can be purchased from brokers or banks for a fee. The federal government offers its new bonds, bills and notes through TreasuryDirect with no fee. After the new bond has been sold, investors buy and sell through brokers and banks.

New Ball Game

However, once you have purchased the bond, if you want to sell it, you are in a new ball game. You must sell the bond in a market place, sort of a used-bond market, and the price is negotiable. It is the prospect of big changes in prices in this huge market that shakes up investors.

If interest rates have risen since you bought the bond, you end up having to sell the bond at below the original price.

Look at it from the buyer's point of view. In the example above, your bond still pays 10 percent interest on $10,000 -- that, is $1,000 a year. But now that interest rates have increased, a buyer can get a new $10,000 bond that pays, say, 12 percent interest, or $1,200 a year.

You will have to agree to a lower price if you want to sell your bond.

The buyer of your bond will still receive the same amount of interest each year. In this example, that is $10,000 (10 percent of the original price). But because the price has changed, the rate of interest, or yield, will change.

If the new price is $9,000, then the new yield is the amount of annual interest, $1,000, divided by the new price, $9,000, which is 11.1 percent. The rules of math require that the same amount of interest divided by a lower price results in a higher yield.

These effects apply to all types of government and corporate bonds that can be sold by the bond holder. They do not apply to U.S. savings bonds, which cannot be sold by the original buyer.

Size Counts

The size of the decline in prices of bonds on the secondary market depends partly on the size of the rise in interest rates. It also depends on the length of maturity; a 10-year bond would be locked into a lower interest rate longer than one with a maturity of five years.

A precipitous rise in interest rates, along with a sharp drop in bond prices, might cause selling pressure to overwhelm buyers. That raises the possibility of a bond market crash. That specter may be present both for corporate bonds and for the usually safer Treasuries, the bonds, bills and notes issued by the U.S. Treasury.