Bond Basics: How Interest Rates Affect Bond Prices

# Interest Rates and Bond Prices: A Year in Dana's Brokerage Account

Dana opened her brokerage app on a Tuesday night and saw a number she didn't expect. The $10,000 she'd put into U.S. Treasury notes four months earlier, the "safe" part of her money, was showing a value of about $9,220. She hadn't missed a payment. The government hadn't defaulted. Nothing was wrong with the bonds.

What changed was interest rates. Understanding how interest rates affect bond prices is the one bond lesson that matters most, and it's the one most people learn the way Dana did: by watching it happen to their own account.

Dana is an illustrative example. Say she's 38, a physical therapist earning $76,000 a year, with a solid emergency fund and a 401(k) she contributes to steadily. She also got a $10,000 bonus that she might use toward a home down payment in a few years. She wanted that money somewhere steadier than stocks. We'll follow her for 12 months.

What Dana Actually Bought

In January, Dana bought ten newly issued 10-year Treasury notes. Each has a face value of $1,000, so she paid $10,000. Each note carries a 4% coupon. The coupon is the fixed interest rate the government promised when the note was issued.

The math on her income is simple:

$10,000 × 4% = $400 per year

Treasury notes pay interest twice a year, so Dana gets $200 every six months. In ten years she gets her $10,000 back. Over the full term, that's $400 × 10 = $4,000 in interest.

Two features of this deal never change, no matter what happens in the economy. The coupon stays at 4%, and the face value stays at $1,000 per note. The thing that does change is what someone else would pay her for those notes if she wanted to sell before year ten. That's the market price, and it's what her brokerage app shows.

One tax detail worth knowing: interest on Treasuries is taxed by the federal government but exempt from state and local income tax. For Dana, that $400 a year shows up on her federal return only.

Why Bond Prices Move Opposite to Rates

Here's the core idea, stripped down. A bond's coupon is locked in. When new bonds start paying more, old bonds with lower coupons become less attractive. The only way to sell an old bond is to cut its price until a buyer earns the same return they'd get from a new one.

A one-year bond makes the logic easy to see. Say you own a $1,000 bond that pays 4% and matures in one year. At maturity you'll collect $1,000 plus $40 in interest, so $1,040 total.

Now suppose new one-year bonds pay 5%. A buyer can put money into a new bond and earn 5%. Why would they buy yours at full price and earn only 4%? They won't. They'll pay whatever price turns your $1,040 payout into a 5% return:

$1,040 ÷ 1.05 = $990.48

Check it: the buyer pays $990.48 and collects $1,040, a gain of $49.52. And $49.52 ÷ $990.48 = 5.0%. Your bond's price dropped about $9.50 so its return could match the new market rate.

Run it the other way and the price rises. If new bonds paid only 3%, your 4% bond would be worth more than $1,000, because buyers would happily pay a premium for the higher coupon.

That's the whole seesaw. Rates up, existing bond prices down. Rates down, existing bond prices up.

When Rates Climbed: Dana's Paper Loss

Back to Dana. By spring, yields on new 10-year Treasuries had risen from 4% to 5%. (This is an illustrative scenario, though moves of that size within a year have happened, including in 2022.)

Dana's notes still pay $20 every six months per note and $1,000 at the end. But a buyer can now get 5% elsewhere, so they'll price her note to yield 5%. That means discounting each future payment at 2.5% per six-month period instead of 2%.

Here's the calculation for one note, rounded and treating it as having roughly ten years (20 payments) left.

The $1,000 repaid at maturity is worth:
$1,000 ÷ 1.025^20 = $1,000 ÷ 1.6386 = $610.27 today

The 20 interest payments of $20 each are worth:
$20 × [(1 − 1 ÷ 1.6386) ÷ 0.025] = $20 × 15.589 = $311.78 today

Add them up:
$610.27 + $311.78 = $922.05 per note

Multiply by ten notes and Dana's position is worth about $9,220. That's a drop of roughly $780, or 7.8%, on an investment people call "safe."

Here's what Dana needs to hear, though. She hasn't lost anything unless she sells. If she holds to maturity, she still collects every $200 payment and still gets her full $10,000 back in year ten. The $780 is a paper loss. It reflects what the market would pay her today, not what she'll receive if she sticks to the original plan.

The real cost of holding is subtler. Someone buying a new note today earns $500 a year on $10,000. Dana earns $400. She's giving up about $100 a year in income compared with what's now available. Over the remaining term, that adds up to roughly the paper loss she's seeing. Selling and reinvesting at 5% doesn't escape that cost. It just locks it in now instead of spreading it out.

Duration: Why a 10-Year Bond Gets Hit Harder

Dana's coworker, also illustrative, bought a 2-year Treasury note with a 4% coupon at the same time. When 2-year yields rose to 5%, his note barely moved. Why?

With only four semiannual payments left, the price math looks like this:

$1,000 ÷ 1.025^4 = $1,000 ÷ 1.1038 = $905.95
$20 × [(1 − 0.90595) ÷ 0.025] = $20 × 3.762 = $75.24
Total: $905.95 + $75.24 = $981.19

His note fell about 1.9%. Dana's fell about 7.8%. Same rate increase, four times the damage.

The reason is time. A buyer of Dana's note is stuck with the below-market 4% coupon for ten years. A buyer of the 2-year note is stuck with it for two. The longer the underpaying stream lasts, the bigger the discount needed to compensate.

Bond people measure this sensitivity with a number called duration. For a 10-year note paying 4% and priced at face value, duration works out to roughly 8. A rough rule of thumb is that a bond's price moves about 1% in the opposite direction for each year of duration, per 1 percentage point change in rates. So:

8 × 1 percentage point ≈ 8% price drop

That's close to the 7.8% we calculated exactly. For a 2-year note, duration is a bit under 2, which lines up with the 1.9% drop.

Duration is the single most useful number on a bond or bond fund's fact sheet. It tells you, in one figure, how much pain or gain to expect when rates move. For Dana, it also exposes a mismatch. She bought a 10-year note with money she might need in a few years. If she has to sell in year three while rates are higher, she takes a real loss. Matching a bond's maturity to when you'll need the money is the simplest way to avoid that.

The Flip Side: What Falling Rates Would Have Done

Suppose things had gone the other way and 10-year yields dropped from 4% to 3% instead. Now Dana's 4% coupon beats the market, and buyers would pay extra for it.

Discounting at 1.5% per six-month period:

$1,000 ÷ 1.015^20 = $1,000 ÷ 1.3469 = $742.47
$20 × [(1 − 0.74247) ÷ 0.015] = $20 × 17.169 = $343.38
Total: $742.47 + $343.38 = $1,085.85 per note

Her ten notes would be worth about $10,860, a gain of roughly 8.6%.

Notice the asymmetry. A 1-point rate rise cost about 7.8%. A 1-point fall would have gained about 8.6%. Bond prices rise a little more when rates fall than they drop when rates rise by the same amount. The technical term is convexity, and for ordinary investors it's a modest, pleasant bonus.

This is also why bonds often help a portfolio during recessions. Central banks tend to cut rates when the economy weakens, which pushes existing bond prices up just as stocks may be falling. That pattern doesn't hold every time, though. It broke down badly in 2022, when stocks and bonds both fell as rates climbed to fight inflation.

Holding Versus Selling, and Where Bond Funds Fit

Dana's choice after the rate jump comes down to one question: will she need this money before 10 years are up?

If she holds to maturity, rate swings don't change her outcome. She gets $4,000 in interest and her $10,000 back, period. The market price on her statement is just noise she can ignore.

If she might need the money in two or three years for a down payment, the swings matter a lot, because she could be forced to sell at whatever price the market offers that day.

Many people own bonds through a bond fund rather than individual notes. A fund works differently in one key way: it has no maturity date. The fund constantly sells older bonds and buys new ones, so it never "gets back to par" the way Dana's individual notes will. A fund's value moves with rates based on its average duration, and that movement doesn't have a guaranteed endpoint.

There's an upside to that structure. When rates rise, a fund reinvests maturing bonds at the new, higher yields, so its income climbs over time. A rough rule: if you hold a bond fund for about as long as its duration, the higher reinvestment income tends to roughly offset the initial price drop from a rate increase. That's an approximation, not a guarantee, but it's a useful way to think about holding periods. To see how reinvested income compounds under different rate scenarios, you can model it with the Compound Interest Calculator.

For Dana's possible down payment, either approach can work if the maturity or duration lines up with her timeline. A 10-year note does not line up with a three-year goal. If you're working backward from a target down payment and a deadline, the Savings Goal Calculator can show how much you'd need to set aside each month.

Dana, 12 Months Later

It's January again. Ten-year yields have stayed around 5%. Dana has held her notes all year.

Her notes now have nine years left (18 semiannual payments), and the market still prices them to yield 5%:

$1,000 ÷ 1.025^18 = $1,000 ÷ 1.5597 = $641.16
$20 × [(1 − 0.64116) ÷ 0.025] = $20 × 14.354 = $287.07
Total: $641.16 + $287.07 = $928.23 per note

Ten notes: about $9,282.

She also collected two interest payments of $200, so $400 in cash.

Her total position: $9,282 + $400 = $9,682.

Compared with her $10,000 starting point, she's down about $318, or roughly 3.2%. That's better than the 7.8% drop she saw in the spring. Two things helped. She collected a year of interest, and her notes moved one year closer to maturity. As a bond approaches its maturity date, its price drifts back toward face value. Economists call this "pull to par." If rates stay put, her notes will creep up each year until they hit exactly $1,000 in year ten.

She owes federal income tax on the $400 of interest, but no state tax. At a 22% federal bracket, that's $400 × 22% = $88.

Dana also made a decision. She still isn't sure about buying a home, but she's decided any down payment money should sit in short-term Treasuries or a high-yield savings account going forward. Her 10-year notes now count as part of her long-term savings, where the paper swings don't threaten a specific goal. Same bonds, different job, and a much better fit.

FAQ

If I hold a bond to maturity, do interest rate changes matter at all?

For an individual bond from a creditworthy issuer like the U.S. Treasury, rate changes won't affect what you get if you hold to maturity. You collect every coupon payment and your full face value. What rates do affect is your opportunity cost. If rates rise, you're earning less than new buyers. Inflation also matters. If it runs higher than expected, your fixed payments buy less over time.

Why do bond funds lose value when rates rise if the bonds inside them pay interest?

The fund's share price reflects the current market value of every bond it holds. When rates rise, those bonds' prices fall, and so does the fund's share price, roughly in line with its duration. The interest keeps flowing and the fund reinvests at higher yields, which helps over time. But a fund has no maturity date, so it never guarantees a return to your original share price.

How can I tell how much a bond or bond fund might drop if rates go up?

Look for its duration, which is listed on most bond fund fact sheets and brokerage bond quotes. FINRA's investor resources explain how to read these documents. Multiply duration by the rate change in percentage points for a rough estimate. A fund with a duration of 6 would fall about 6% if rates rose 1 point, and gain about 6% if they fell 1 point. Shorter duration means smaller swings in both directions.

This article is for educational purposes only and is not personalized financial advice.