Why Rising Rates Hurt Bonds
FIXED INCOME
“When interest rates rise, bond prices fall.” — Benjamin Graham
Why Rising Rates Hurt Bonds
The relationship between interest rates and bond prices is the most fundamental principle of fixed-income investing. It is also the most frequent source of confusion for retail investors.
Many investors allocate to bonds under the assumption that they are "safe" assets—instruments designed to preserve capital regardless of market conditions. While bonds generally offer lower volatility than equities, they are not immune to price fluctuations.
Understanding why bond prices fall when interest rates rise is not a matter of market sentiment or economic speculation. It is a matter of simple arithmetic. To manage a portfolio effectively, one must understand the mechanics of this inverse relationship.
This article serves as a deep dive into the structural reasons for bond price volatility. For a broader perspective on how these assets fit into a total return strategy, see our guide: [Fixed Income: The Asset Class Most Investors Misunderstand].
The Mechanics of Opportunity Cost
At its core, a bond is a contract. An investor lends a specific amount of capital to an issuer (a government or corporation) in exchange for regular interest payments (coupons) and the return of the principal at a set date (maturity).
When interest rates in the broader economy rise, the central bank or the market is effectively saying that the "cost of money" has increased. New bonds being issued will now offer higher coupon rates to reflect this new environment.
Imagine you own a bond with a 3% coupon. If interest rates rise and new, similarly risky bonds are issued with a 5% coupon, your 3% bond becomes less attractive. No rational investor will buy your bond at its original face value when they can purchase a new one that pays more interest.
To make your 3% bond sellable in the secondary market, its price must drop until its "yield to maturity" is roughly equal to the new 5% market rate. This is the essence of opportunity cost. The price of an existing bond must adjust downward so that its total return—interest plus capital gains—matches the current market environment.
Understanding Duration: The Sensitivity Metric
Not all bonds react to interest rate changes with the same intensity. The primary metric used to measure this sensitivity is "duration."
Duration is expressed in years, but it is not the same as the time remaining until maturity. It is a calculation that accounts for the timing of all future cash flows, including interest payments and the final principal repayment.
The rule of thumb for duration is straightforward: for every 1% change in interest rates, a bond’s price will change by approximately 1% in the opposite direction for every year of duration.
For example:
A bond fund with a duration of 2 years will see a price decline of approximately 2% if rates rise by 1%.
A bond fund with a duration of 10 years will see a price decline of approximately 10% if rates rise by 1%.
This explains why long-term Treasury bonds are significantly more volatile than short-term Treasury bills. The longer the investor has to wait for the return of their principal, the more opportunities there are for interest rates to change, and the more "discounting" must be applied to those distant cash flows.
[Internal link: Duration and Convexity: Measuring Bond Risk]
The Discounting of Future Cash Flows
To understand why longer-dated bonds suffer more, we must look at the concept of Present Value (PV).
A bond is simply a series of future cash flows. To determine what those future payments are worth today, investors apply a "discount rate." This discount rate is heavily influenced by prevailing interest rates.
When interest rates rise, the discount rate applied to future cash flows also rises. Mathematically, as the denominator in a fraction increases, the total value decreases. Because long-term bonds have cash flows that occur 10, 20, or 30 years in the future, the impact of a higher discount rate is compounded over time.
A dollar received in 30 years is worth significantly less today when interest rates are 5% than when they are 1%. This mathematical reality is what drives the steep price declines seen in long-duration assets during rate-hiking cycles.
The Reinvestment Silver Lining
While rising rates cause immediate pain in the form of price depreciation, they are a long-term benefit to the fixed-income investor. This is the primary tradeoff of the asset class.
Fixed income provides two sources of return: price changes and income (yield). When rates rise, the price component suffers, but the income component improves.
For a long-term investor, falling bond prices allow for the reinvestment of coupons and maturing principal into new bonds with higher yields. Over time, the increased income generated by these higher yields will typically offset the initial capital loss.
This creates a "recovery period." If an investor’s holding period is longer than the duration of their bond portfolio, rising interest rates will eventually result in a higher ending wealth than if rates had remained low. The volatility is the mechanism through which the portfolio's yield is reset to a more attractive level.
[Internal link: The Role of Bonds in a Diversified Portfolio]
Individual Bonds vs. Bond Funds
A common misconception among retail investors is that individual bonds are "safer" than bond funds because individual bonds can be held to maturity to "avoid a loss."
This is a behavioral distinction, not a mathematical one.
If you hold an individual bond and rates rise, the market value of that bond still declines. You may choose not to sell it, and you may eventually receive your $1,000 principal back at maturity, but you have still suffered an "opportunity loss." You are locked into a below-market interest rate for the remaining life of the bond.
A bond fund is simply a collection of individual bonds. The fund’s Net Asset Value (NAV) reflects the actual market value of its holdings every day. While the fund’s price fluctuates, it is also constantly reinvesting maturing bonds into new, higher-yielding ones.
Whether you hold an individual bond or a fund, the underlying economics are identical: rising rates reduce the current value of your fixed-rate payments. The only difference is how the loss is accounted for and perceived.
Discipline Over Optimization
The urge to "timer" interest rate moves is high among investors, but the success rate is low. Predicting the path of interest rates requires predicting inflation, economic growth, and central bank policy—variables that even professional economists struggle to forecast accurately.
For the disciplined investor, the goal is not to avoid rising rates, but to match the duration of their bond holdings to their specific time horizon.
If you require your capital in two years, holding long-term bonds is an inappropriate risk, as a rate spike could force you to sell at a loss. However, if you are investing for a retirement 20 years away, short-term price fluctuations caused by rising rates are largely irrelevant to your long-term outcome.
Summary
Rising interest rates hurt bond prices because existing fixed payments become less valuable when newer, higher-paying options become available. This is a structural, mathematical reality of the financial markets.
Price and yield move in opposite directions.
Duration measures the sensitivity of this movement.
Longer-term bonds are more sensitive than shorter-term bonds.
Short-term price losses lead to higher long-term reinvestment yields.
Rational investing requires accepting that "safe" does not mean "stable." Bonds provide a predictable stream of income and a contractual return of principal, but the path to that maturity will always be influenced by the shifting cost of money. Maintain a focus on your total investment horizon, and view duration as a tool to be managed rather than a threat to be feared.