[Investment] Explaining the mechanism of how bond prices fall when interest rates rise

Why does it matter to us that bond prices fall when interest rates rise?

It deeply affects our daily lives, such as in asset management and home loans.

• Interest rates and bond prices have an inverse correlation

• Longer-term bonds have greater price volatility

• Holding to maturity ensures principal repayment in principle

Click here for the video version with illustrations: https://www.youtube.com/watch?v=69KN6-0jXS0

Rising interest rates and their impact on daily life

The mechanism by which bond prices fall when interest rates rise may sound complicated at first glance. However, this is an important topic directly related to our daily lives, such as our asset management and home loans. This mechanism affects the market value of bonds you hold and the yields of bonds you might purchase in the future.

The link between interest rates and bond prices

Interest rates and bond prices move in opposite directions, like a seesaw. The main reason for this is that investors seek more favorable conditions, which changes the attractiveness of newly issued bonds versus existing ones. The face value is the base amount, and the interest rate (coupon) is the annual interest percentage relative to the face value. When market interest rates rise, the interest rates on newly issued bonds also increase. Consequently, existing bonds with lower interest rates become relatively less attractive, and their prices fall. By falling in price, the yield of existing bonds is adjusted to match market interest rates. Conversely, if interest rates fall, the interest rates on newly issued bonds also decrease, making existing bonds relatively more attractive, and their prices rise.

Duration and the magnitude of price fluctuations

The longer the time to maturity, the greater the price fluctuation caused by interest rate changes. For example, for a bond with a 3% interest rate, if market interest rates rise by 1% from 3% to 4%, the price of a 5-year bond will fall by approximately 4.49%, a 10-year bond by about 8.18%, and a 30-year bond by about 17.38%. The indicator that shows sensitivity to interest rate changes is “duration.” This represents the approximate percentage change in price when interest rates change by 1%. If the modified duration is 5 years, a 1% rise in interest rates will cause the price to fall by approximately 5%. Because interest payments are received, duration is usually shorter than the remaining time to maturity.

Holding to maturity and the risk of selling mid-term

Bond investment has an important premise: “If you hold until maturity, you will generally not lose your principal.” As long as the issuer does not go bankrupt, you will be repaid the face value (100%) if you hold the bond until the maturity date. However, caution is required if you sell before maturity. In a rising interest rate environment, the market price at that time may fall below your initial investment. Also, the possibility that an issuer cannot repay the principal or pay interest due to bankruptcy or other reasons is called “credit risk.” Generally, government bonds are considered to have lower credit risk than municipal or corporate bonds. It is important to check the financial status of the issuer of the bonds you are investing in.

Actions to take for investment

Rising interest rates cause the prices of existing bonds to fall, but holding to maturity generally ensures principal repayment. Selling mid-term carries the risk of price fluctuations. To apply this knowledge, it is important to understand the maturity, interest rate, and “yield to maturity” if held until the redemption date as a basis for investment decisions. Some bonds have mechanisms to suppress interest rate fluctuation risk. For example, individual government bonds (10-year floating rate) have an applicable interest rate of the base rate × 0.66, with a minimum guarantee of 0.05%. Mid-term redemption is possible after one year, but fees apply. By calculating the impact on your assets and deepening your knowledge, you can understand the risks and make wise choices.

Video version

This article is a rewritten version of a YouTube video. Click here for the video with illustrations: https://www.youtube.com/watch?v=69KN6-0jXS0

*The audio is synthesized using VOICEVOX. AI was used to create the script.