How do interest rates affect bonds?

Juan Nozal, fund manager at MAPFRE AM

A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions. Additionally, bond yields move in the same direction as rates. In short, when market interest rates rise, the price of fixed-rate bonds falls, yields go up, and vice versa. This gives rise to what is known as interest rate risk, namely the risk that the value of an investment will fluctuate as a result of changes in interest rates.

For an investor who intends to hold the bond all the way to maturity, interest rate risk may be less of a concern than it would be for another investor who might need to sell the bond before it reaches maturity and may be forced to sell it at a discount to par value, i.e. below the bond's initial purchase price. Interest rate risk also affects bonds differently based on the features of the bonds (maturity date, coupon rate, or embedded options).

When interest rates are falling, new bonds will pay investors lower interest rates than old ones, so old bonds tend to rise in price above their initial par value in the secondary market (the coupon payments remain unaffected), and there may be an opportunity to profit if an investor sells the bond before maturity.

On the other hand, higher interest rates make the fixed return of existing bonds become less appealing to investors. In order for the bond to become more attractive to investors in this situation, the price has to fall to make it a more competitive investment. So, when the bond price drops, its yield goes up, making it competitive against newer bonds paying higher rates. (Current yield = annual coupon ÷ bond price.)

If you’re a fixed income investor, interest rates have a direct impact on your income. However, changes in rates aren’t the only factor that can cause bond prices to fluctuate. Other factors include supply and demand or any news about the financial health of the issuer that could impact its ability to meet the obligations of the bond.

Generally speaking, the severity of this impact on can be measured by looking at the bond’s duration. Duration is used to estimate how sensitive a particular bond’s price is to interest rate movements. While duration is not the same as a bond’s maturity date, it’s true that bonds with long maturities are generally more sensitive to interest rate movements, while bonds with shorter maturities are less sensitive.

An approximate method to determine the interest rate impact on the value of your bonds is to multiply the duration by the interest rate change. So if your $1,000 bond had a duration of 10 years, a 1% rate increase by the FED or the ECB would cause the value of the bond to fall by approximately 10%. If rates go up by 2%, the value will fall by 20%, and so on.