How Bond Prices and Interest Rates Move

Introduction

One of the most confusing ideas in investing is that bond prices and interest rates move in opposite directions. When rates go up, bond prices go down. Once you understand why, it makes perfect sense.

How Bonds Work

When you buy a bond, you are lending money in exchange for regular interest payments and your money back at the end. Imagine you buy a bond for $1,000 that pays 3% interest, or $30 a year. That rate is locked in for the life of the bond.

Why Prices Change

Now imagine interest rates rise, and new bonds pay 5%, or $50 a year. Nobody would pay $1,000 for your bond paying only $30 when they could buy a new one paying $50. To sell your bond, you would have to lower the price. The opposite happens when rates fall. Your 3% bond becomes more attractive, and its price rises.

Duration and Risk

Longer-term bonds are more sensitive to interest rate changes because their payments stretch further into the future. In 2022, when the Federal Reserve raised rates quickly, many long-term bond funds lost more than 15% of their value. Short-term bonds were affected much less.

Conclusion

Bond prices and interest rates are like two ends of a seesaw. Understanding this relationship helps you make smarter decisions about bonds and your whole portfolio!