Why Are Rising Interest Rates Bad For Bondholders?

There has been much conversation about the Federal Reserve raising interest rates. Interest rates and bond prices have an inverse relationship. That is, as rates rise, bond prices fall. But why?

The answer is best illustrated with a simple example. Say XYZ company issues a 10 year bond at $1000, or par value, and pays a 3% coupon payment each year. You purchase the bond for $1000 and receive $30 each year for 10 years, at which point you receive the $1000 par amount back. This is a simple total return of $300.

Now suppose the day after you buy the bond, interest rates rise. New bond buyers can now purchase a bond from a comparable company for $1000, at 6%. Your 3% bond has become less attractive to buyers because they can purchase bonds at a higher rate of 6%. They would earn twice the amount of interest over the 10 years. To compensate, the price of your 3% bond will fall below $1000. Why? It must fall to the point where a new buyer would be indifferent between purchasing your bond or the new 6 % bond. The decrease in price increases the overall return for the new buyer because they get the $1000 par at maturity which is greater than the price they paid for the bond.

*image courtesy of RBC Global Asset Management