The relationship between bond values and interest rates is core knowledge for an investor in bonds, Treasury securities or even bond mutual funds. Treasuries are one type of bonds and are the simplest in function. If you know how Treasury securities will react to rising interest rates, you understand the effects on the rest of the bond market.
How Bonds Function
The typical bond -- including Treasury notes and bonds with initial maturities from two to 30 years -- pay a fixed rate of interest each year based on the face value of the bond, and the face amount is paid off when the bond matures. For example, if you own a $100,000 Treasury bond that has a 6 percent coupon rate and matures in 10 years, you will receive semiannual interest payments of $3,000 and the $100,000 face value on the maturity date in 10 years.
Since the interest paid by a bond and the face value are fixed values, the bond market mechanism to adjust for changing interest rates is to change the current market price of a bond. As a result of how bond markets function, you may pay more or less than the face value to purchase a specific bond. In bond market jargon, a bond can be a premium or discount bond. Bond prices are always quoted as a percent of the face value, so a $100,000 Treasury bond quoted at 98.525 would cost $98,525 and be a discount bond.
An inverse relationship exists between bond prices and interest rates. If you own a bond paying a certain rate of interest and rates in the bond market go up, a buyer will not pay you the same price you paid for the bond. The price will be lower to bring the yield based on price in line with current market rates. So if rates increase, the market prices for bonds decrease. If rates go down, the market value of bonds goes up. Longer-term bonds have greater price volatility than will bonds with a shorter time to maturity.
Rising Rate Consequences
If you own a Treasury security or other bond, rising interest rates will not affect the interest you earn or the face value amount you would receive when the bond matures. However, the higher rates will cause the current market value of your bond to decline, so if you wanted to sell the bond, the amount you receive would be less than the bond's value when rates were lower. Because rising interest rates result in lower bond prices, the investment world's view is that rising rates are a negative for bonds.
- Jupiterimages/Photos.com/Getty Images