Why Bond Prices and Yields Move in Opposite Directions

Why this matters

It surprises many people that a "safe" government bond fund can fall in value, sometimes sharply, when interest rates rise. Once you see why, it stops being surprising, and you'll understand one of the most important forces in all of investing: the effect of interest rates on what investments are worth.

The basic idea

Imagine you own a bond paying 3% a year. Then interest rates rise, and new bonds of the same quality pay 4%. Nobody will pay you full price for your 3% bond when they could buy a new one paying 4%. To sell it, you'd have to accept a lower price, low enough that the buyer's return works out to about 4%.

It works the other way too. If rates fall to 2%, your 3% bond pays more than new bonds, so buyers will pay more for it.¹ Higher market interest rates mean lower prices for existing fixed-rate bonds, and lower rates mean higher prices.¹

Coupon and yield

Two numbers are easy to mix up:

• The coupon is fixed when the bond is issued. It's a percentage of face value: a 3% coupon on $1,000 pays $30 a year, no matter what.
• The yield is the return you'd actually earn based on the price you pay. Buy that bond for less than $1,000, and your yield is higher than 3%. Pay more, and it's lower.

Because the payments are fixed, a lower price means a higher yield and a higher price means a lower yield. That's what "prices and yields move in opposite directions" means. The most complete measure, yield to maturity, counts both the interest and the gain or loss from the price you pay compared with the face value you'll get back.

A $1,000 bond with a 3% coupon has one year left. To keep the math simple, assume it pays its final $30 of interest and the $1,000 at maturity, so the buyer receives $1,030 in a year.

If new one-year bonds yield	What a buyer would pay	Why
3%	$1,000.00	$1,030 is exactly a 3% return on $1,000
4%	About $990.38	$1,030 ÷ 1.04: the price that gives a 4% return
2%	About $1,009.80	$1,030 ÷ 1.02: the price that gives a 2% return

The bond's payments never changed. Only the price changed, to match what new bonds offer.

Longer bonds swing more

A bond with many years left locks in its coupon for longer, so a change in rates matters for longer. That's why bonds with longer maturities generally carry more interest rate risk than similar bonds with shorter maturities.¹

Hypothetical $1,000 bonds with a 3% coupon, simplified to pay interest once a year. What they'd be worth if market rates moved from 3% to 4%, or to 2%:

Years to maturity	If rates rise to 4%	If rates fall to 2%
1	$990 (−1%)	$1,010 (+1%)
2	$981 (−2%)	$1,019 (+2%)
10	$919 (−8%)	$1,090 (+9%)
30	$827 (−17%)	$1,224 (+22%)

A one-point rate change barely moves a one-year bond but moves a 30-year bond by close to a fifth. Long-term bonds are not a low-risk choice when rates can change.

Holding to maturity

If you hold an individual bond until it matures and the issuer doesn't default, you'll receive all the interest and the full face value, whatever happened to its price along the way. The price matters if you need to sell early. A bond fund is different: it holds many bonds and keeps replacing them, so it never "matures," and its price keeps reflecting interest rates. Bond Funds vs. Individual Bonds in the Fixed Income depth track covers the difference in detail.

Key takeaways

• When market interest rates rise, existing fixed-rate bond prices fall, and vice versa.
• The coupon is fixed. The yield depends on the price you pay and moves opposite to it.
• Longer-term bonds react more to interest rate changes.
• Held to maturity without default, an individual bond pays what it promised regardless of price swings.

Check your understanding

You own a bond paying 5%. Market rates for similar bonds fall to 3%. What happens to your bond's price?

1. It rises, because your bond now pays more than new ones.
2. It falls, because lower rates make all bonds less valuable.
3. It stays at face value until it matures, whatever rates do.

Rates rise by one percentage point. Which of these would likely fall the most in price?

1. A Treasury bill maturing in three months.
2. A five-year Treasury note.
3. A 30-year Treasury bond.

What's next

Interest rates are one risk. Whether the borrower pays you back is the other. The next lesson, Treasuries, Corporate Bonds, and Munis, compares the main kinds of bond issuers and how credit ratings work.