Existing bonds will fall in value when interest rates rise because there’s an inverse relationship between rates and yields. The impact of rising rates on bond yields is important for investors to understand so that they can prepare themselves for times when rates go up.
It seems wrong that bonds can actually fall in price if yields rise since higher interest rates should create more income on a bond investment.
But the danger to bond prices is much higher than at any time in recent memory with the extremely low yields in the bond market, which make bonds more sensitive to changes in yields.
There is also danger from a historical point of view: most bond traders and investors have little experience with rising rates, since rates have been at lows not seen in decades because of the fallout from the 2008 financial meltdown.
But it’s important to keep in mind that there is an inverse correlation between bond yields and interest rates, and it isn’t intuitive.
Existing bonds with a fixed coupon fall in value when new bonds are issued with higher coupons, since people don’t want to pay for an old bond with a lower rate when they now can, for the same amount, get a new bond with greater value.
And that has to do with yet another relationship, this time between outstanding bond coupon payments and the coupons of new bonds issued at higher interest rates.
Bonds have a fixed coupon that is payable until maturity. If yields increase, bonds fall, and once investors start to see rising yields, they start to sell off their holdings.
Whether or not that’s the right move will depend on a number of factors, such as date of maturity and duration of the bond – so it pays to understand how bonds work as well as the impact of rising rates on bond yields and their value before making any decisions.
To read more about how interest rates affect bonds, click here.