Bond Yields and Interest Rate Risk, Explained
Why does a bond you already own lose value when interest rates rise? The answer comes down to one simple relationship between price and yield.
Coupon rate vs. yield: not the same thing
A bond's coupon rate is fixed at issuance and never changes — it's simply the stated annual interest rate on the bond's face value. Yield is different: it's the actual return an investor earns based on what they paid for the bond, which can be above or below face value once the bond starts trading. A bond with a 4% coupon purchased at a discount for $950 instead of its $1,000 face value delivers a yield higher than 4%, because the buyer is getting the same fixed payments for less money upfront.
The seesaw: price down, yield up
This relationship — bond prices and yields moving in opposite directions — is the single most important idea in fixed income investing. Picture two otherwise identical bonds: an older one paying a 3% coupon, and a newly issued one paying 5%, because the general level of interest rates rose after the older bond was issued. No one would pay full face value for the 3% bond when a 5% bond is available instead. So the market price of the older bond falls until its yield, based on the new, lower price, becomes competitive with the 5% bond. The coupon payment itself never changes — only the price investors are willing to pay for it.
Why interest rates move bond prices at all
Interest rates set by central banks and reflected across the broader economy influence what any new borrower, government or company, has to pay to borrow money. When rates rise broadly, newly issued bonds come with higher coupons to match. That makes existing, lower-coupon bonds relatively less attractive, so their prices fall. When rates fall, the opposite happens: existing higher-coupon bonds become more valuable by comparison, and their prices rise.
- Rising interest rates: existing bond prices tend to fall.
- Falling interest rates: existing bond prices tend to rise.
- A bond held to maturity still returns its full face value regardless of these price swings in between — the price risk mainly affects investors who need to sell before maturity, or funds that are marked to market.
Duration: measuring the sensitivity
Not all bonds react to rate changes by the same amount. Duration is a measure, expressed in years, of how sensitive a bond's price is to a change in interest rates — roughly speaking, a bond with a duration of 7 years will lose about 7% of its value for every 1-percentage-point rise in rates, and gain about the same for a 1-point drop. Longer-maturity bonds generally have higher duration and are more sensitive to rate changes; shorter-maturity bonds have lower duration and are more stable.
Duration is the closest thing bond investing has to a speedometer — the higher the number, the faster a bond's price reacts to changing rates, in either direction.
What this means for a bond investor
If you expect to need your money on a specific date, a bond, or a bond fund with a similar average maturity, that matures around that date sidesteps most rate-risk concerns entirely. If you're investing for the long run and don't need the money soon, short-term price swings in a bond fund caused by rate changes matter less, since the underlying income the bonds generate is what compounds over time.
This article is educational and general in nature. It isn’t personalized investment, tax, or legal advice — always weigh your own circumstances, or talk to a licensed professional, before making financial decisions.