Bonds: lending your money
Why bond prices fall when interest rates rise, in one simple example.
A bond is a loan
When you buy a bond, you lend money to a government or company. In return, they usually pay you regular interest (the coupon) and promise to repay the original amount (the face value) on a set date (maturity).
US Treasury bonds are backed by the US government and considered very safe from default. Corporate bonds pay more, because companies are more likely to fail to repay. Bonds from borrowers with a higher risk of default, rated below 'investment grade', are called high-yield or junk bonds.
Yield
A bond's yield is the return you'd earn if you bought it at today's price and held it to maturity. When you see 'the 10-year Treasury yield', that is the yield on US government debt maturing in 10 years. It is closely watched because it influences mortgage rates and many other borrowing costs.
Why prices fall when rates rise
Imagine you own a bond paying 3%. Then new bonds start paying 5%. Nobody will pay full price for your 3% bond when they could get 5% elsewhere, so its price has to drop until its yield matches the market. When rates fall, the opposite happens and older, higher-paying bonds become more valuable.
The longer until a bond matures, the more its price moves when rates change. Short-term bonds barely budge; long-term bonds can swing a lot. If you hold a high-quality bond to maturity, you still get the full face value back, as long as the issuer doesn't default.
Bonds in a portfolio
Bonds have usually swung less than stocks and paid steadier income, so people often use them to soften a portfolio's ups and downs. But they are not risk-free: inflation, rising rates and defaults can all hurt.
A bond will pay you $1,030 in one year: $1,000 face value plus $30 interest (a 3% coupon).
If new one-year bonds suddenly pay 5%, what would a buyer pay for your bond? The price at which $1,030 is a 5% gain: $1,030 / 1.05 = about $981. Your bond's price fell about $19.
If instead rates fell to 1%, buyers would pay $1,030 / 1.01 = about $1,020. Your bond rose in value.
Key terms
- Bond
- A loan to a government or company that pays interest and returns your money at maturity.
- Coupon
- The interest a bond pays, usually as a fixed percentage of its face value.
- Yield
- The return you'd earn buying a bond at today's price and holding it to maturity.
- Maturity
- The date when a bond's face value is repaid.
Bond prices and interest rates move in opposite directions.