Changes in interest rates can significantly affect the value of bond investments, even though the terms of the asset itself remain unchanged. Understanding this mechanism helps investors better assess potential price fluctuations, expected returns, and the risks associated with market developments.

Why Interest Rates Affect Bonds

A bond can be understood as a loan that an investor provides to a government, company, or another issuer. The issuer commits to paying an agreed interest payment, known as a coupon, and returning the bond’s face value at maturity. Although these terms remain unchanged for fixed-rate bonds, their market price continuously responds to the yields available in the market. When interest rates rise, older bonds with lower coupons become less attractive, and their price generally falls. Conversely, when rates decline, these bonds become more appealing, which may support an increase in their price (to learn more about the basic characteristics of bonds and how they differ from stocks, read our previous article).

Key Terms Every Investor Should Know

Face value is the amount the issuer pays at maturity, while the market price represents the bond’s current value on the secondary market. The coupon is the regular interest payment, and the coupon rate determines its amount as a percentage of the face value. The maturity date is also important, as this is when the issuer repays the principal to the investor. However, the coupon rate is not the same as the actual yield, since the yield also depends on the price at which the investor buys or sells the bond.

Why Bond Prices Fall When Interest Rates Rise

Imagine a bond with a face value of €1,000 and a coupon rate of 3%, generating €30 per year. If newly issued bonds begin offering 5%, an investor can receive €50 per year for the same face value. The older bond therefore becomes less attractive, and its price must fall. The €30 coupon remains unchanged, but relative to the lower purchase price, it represents a higher percentage return. In this way, the yield on the older bond gradually moves closer to the new market conditions (we explain in greater detail why the investment period should correspond with the investor’s objectives in our article about the investment horizon).

Why Bond Prices Rise When Interest Rates Fall

If new bonds begin to be issued with a coupon rate of only 2%, they will generate €20 per year on a face value of €1,000. An existing bond paying a €30 coupon is therefore more attractive, and investors are willing to pay more for it. Its price may rise above its face value, reducing the yield relative to the higher purchase price. The price continues to rise until the bond’s yield approaches the level currently available in the market.

A Bond’s Coupon Is Not the Same as Its Yield

The coupon payment is always calculated from the bond’s face value, not its current market price. A bond with a face value of €1,000 and a 3% coupon therefore pays €30 per year, regardless of whether it is trading at €900 or €1,100. The yield is higher at a lower purchase price and lower at a higher purchase price. A more accurate measure is the yield to maturity, which takes into account the coupon payments, purchase price, remaining term, and the amount repaid at maturity.

Why Some Bonds Are More Sensitive

Bonds with longer maturities generally react most strongly to changes in interest rates. Investors remain locked into the original coupon for a longer period, which means that changes in market conditions have a greater impact on the bond’s price. Bonds with lower coupons also tend to be more sensitive. Interest-rate risk can be estimated using duration, which, in simplified terms, indicates by how many percent a bond’s price may change when yields move by one percentage point. A higher duration means greater potential price fluctuations.

The Role of Central Banks and Market Expectations

The interest-rate environment is largely influenced by central banks. When inflation is rising, they may increase interest rates, which supports higher yields on newly issued bonds and pushes the prices of older bonds lower. When economic growth slows or inflation declines, they may instead reduce rates, making existing bonds with higher coupons more attractive. However, markets often react to economic data and expectations in advance, meaning that bond prices may move even before a central bank announces its decision.

What This Relationship Means for Investors

If an investor holds a high-quality bond until maturity, a temporary decline in its market price does not necessarily result in a realised loss. The investor may continue receiving coupon payments and recover the bond’s face value at maturity. The risk becomes more significant when the bond needs to be sold earlier. Bond funds and ETFs also generally do not have a single fixed maturity date, which means they may remain exposed to interest-rate changes for longer. When selecting an investment, investors should therefore consider not only the coupon, but also the yield to maturity, duration, remaining maturity, and the issuer’s credit risk.

For more investment trends and useful tips, explore our previous articles on the AxilAcademy website.