Why to Bond Prices go down when Interest Rates go up?
If you listen to business news reports, you’ll often hear them say something like the following: “Interest rates are up. The yield on the yield on the 10-year T note increased to 4% and bond prices fell”. So what does that all mean anyway and why do bond prices fall when interest rates rise? This is something that took me a long time to figure out and when I finally learned it, I was really happy.
So, let’s unpack those sentences.
“Interest rates are up” – That is something we are all feeling these days as interest rates of mortgages, car loans, credit card debt and everything else are rising.
“The yield on the yield on the 10-year T note increased to 4%” – This one takes a little longer to explain. A “T note” is a “Treasury Note”, essentially a loan taken by the US government to finance its massive debt. The 10 year note is a loan that is due in 10 years (there are other notes with different durations). Since the US government has so much debt, and the US government is the most credit-worthy organization in the world, it is typically the lowest interest rate around and doesn’t move around that much, except when overall interest rates are rising like today. When that happens, the T-note moves with interest rates. Therefore, for many years people have used the T-note as a benchmark for all interest rates. So far so good.
“and bond prices fell.” - This was the confusing one. So, if interest rates are going up why would bond prices fall? Bonds pay out dividends based on the interest rate so if interest rates go up wouldn’t the bonds pay out more and be more valuable? Yes, that is all true, but the key here is that we are talking about OLD bonds, not new ones. So, new bonds do have to have higher interest rates so you do make more from bonds that are issued when interest rates are higher. But OLD bonds already have their interest rates locked in when they are issued. If you were to try and sell that bond today, people wouldn’t be interested in it since new bonds have higher interest rates so you’d need to offer it at a discount to get people to buy it. In fact, you can calculate exactly how much discount you’d need to offer – the price for the old bond would have to be set so that a buyer would be indifferent between buying a new bond at a higher interest rate and buying your old bond at a lower interest rate.
For example, for simplicity, let’s take two bonds – “new bond” and “old bond” and let’s look at a 1 year term for the new bond. “New bond” you can buy for $100 today and it pays 10% interest in one year. So, if you invested $100, you’d get $110 at the end of the year.
You bought “old bond” last year ago also for $100 when interest rates were lower, and you are being paid 5% interest. It is set to mature in one year (it was originally a 2-year bond). So, if interest rates hadn’t changed, your bond would be worth $105 after one year and $110 after the second year (it’s actually a little higher because of compound interest but ignore that for this example). If you wanted to sell your bond after one year, you would expect that someone would buy it for $105 (they’d make 5% interest on the next year).
But rates did change, and you want to sell it now. Today, a buyer can buy a new 10% bond and get paid $110 at the end of the year. Or they could buy your bond, and also receive $110 at the end of the year. So, how much will they give you for your bond – Yup, $100. Your bond dropped in price.
And that’s why bonds drop in price when interest rates rise. The bonds value didn’t actually change – it will still pay the same amount you thought it would when you bought it. But the amount you’d get to sell it to someone else drops.