Why Do Bond Prices Fall When Interest Rates Rise?

As interest rates rise, you’ve probably heard people say things like “bond yields are falling,” “bond prices are falling.”

But some people also ask, “Aren’t bonds supposed to be products that can’t lose value?”

That’s true—if you hold the bond you own all the way to maturity (the end of the contract).

Let’s walk through this in simple terms.

Say I buy a 10-year, $1,000 bond when the interest rate is 1%. I receive $10 in interest every year, so 10 years from now I’ll have received $1,100 in total, including principal and interest.

But the very next day, the interest rate suddenly jumps to 5%. If I now buy the same 10-year bond for $1,000, 10 years from now I’ll receive $1,500 in total, including principal and interest.

In that case, as the person who bought a bond paying 1% just a day earlier, I’d love to get a refund on yesterday’s bond and buy the new one instead.

But that’s not how it works. Bonds don’t come with refunds. If I want out, I have to sell the bond in the market.

Buyers in the bond market see that rates have jumped to 5%. They want bonds that pay 5% a year; they’re not interested in my bond that only pays 1%.

So I’m forced to sell my bond at a discount. How big a discount? Roughly 31%.

Why would I have to sell a bond I bought for $1,000 for just $691.13—a discount of about 31%?

Because if someone buys my bond now, the yield is otherwise far too low. Even if they receive $10 in interest every year, that’s only about 1.4% relative to a purchase price of $691.13.

So they need to make it up on the back end. If they pay $691.13 today and receive $1,000 back in 10 years, they earn a total return of roughly 45% over the period.

In short, I have to sell my bond at a discount so that the buyer earns essentially the same return as they would on a newly issued bond.

Otherwise, my bond simply won’t sell.

Three-line summary: