The Relationship Between Interest Rates and Bonds
- Ethan Barry
- 1 day ago
- 3 min read
Introduction
With the Federal Reserve’s recent announcement that is will drop interest rates, many investors are asking how a rate change could impact their portfolios. One of the most important — yet often misunderstood — relationships in finance is that between interest rates and bond prices. In this article, we’ll break down how they interact and why changes in rates can directly affect the value of your bond holdings.
What Is a Bond?
A bond is essentially a loan made by an investor to a government or corporation. In return, the issuer agrees to pay interest (called the yield) and return the principal at maturity.
A bond’s yield represents the return an investor receives based on its interest rate and current market price. The key relationship to remember is this:
When bond prices rise, yields fall.
When bond prices fall, yields rise.
To keep the example simple, let’s use a zero-coupon bond, which doesn’t pay interest during its term. Instead, investors buy it at a discount and receive its full par value at maturity. The difference between the purchase price and the par value represents the investor’s return.
Example: How Rate Changes Affect Bond Prices
Suppose a zero-coupon bond sells for $980 with a $1,000 par value and matures in one year. The return, or yield, on this bond is about 2.04%.
Now, imagine that interest rates rise, and new bonds are issued offering a 5% yield. Compared to these new bonds, the existing 2.04% bond looks much less attractive. To remain competitive, the price of the older bond would have to drop to about $952.38, aligning its yield with the new market rate of 5%.
The reverse is also true. If interest rates fall, existing bonds with higher yields become more desirable, and their prices typically increase.
It’s also important to note that a bond’s duration — its sensitivity to interest rate changes — plays a role.
When rates are rising, investors often prefer shorter-duration bonds, which are less affected by price declines.
When rates are falling, longer-duration bonds tend to perform better because they gain more from the decline in rates.
The Federal Funds Rate Explained
The Federal Funds Rate is the interest rate at which banks lend money to one another overnight to meet reserve requirements set by the Federal Reserve.
While the Fed doesn’t directly set this rate, it establishes a target range, and the rate typically stays within that range based on supply and demand in the interbank lending market.
The Federal Open Market Committee (FOMC) meets eight times a year to review economic conditions and adjust this target as needed. The federal funds rate influences the cost of borrowing across the economy — including mortgage rates, credit card rates, and, importantly, bond yields.
Conclusion
In short, interest rates and bond prices move in opposite directions:
When rates rise, bond prices fall.
When rates fall, bond prices rise.
This inverse relationship exists because newly issued bonds adjust to the new market rates, making existing bonds with lower yields less appealing (and therefore cheaper).
Understanding this dynamic is crucial for investors, especially in times of changing monetary policy. Whether you’re holding bonds for income, diversification, or stability, knowing how rate movements affect your bond values can help you make more informed investment decisions.
Similar to diversification with stocks, it’s important to build the bond portion of a portfolio to provide stability and a consistent yield across various durations. Your Whitaker-Myers investment committee considers all of these dynamics when designing your portfolio.
