How Rising Interest Rate Affect Bonds

How Rising Interest Rate Affect Bonds


Last year, market analysts predicted, and rightly so, that the Federal Reserve would increase short-term interest rates. This development caused worry among many investors in regards to “fixed-income securities since the consumer would ultimately experience the resultant ripple effect if indeed long-term rates assumed the same trajectory (Lynchburg Business, 2015). This increase has led to unprecedented decline in the value of current bonds, which have fallen to historical low since investors are not willing to pay the full amount for bonds with lower returns given that fact that the market is issuing fresh bonds at an elevated rate. However, those owning or planning to hold bonds until they mature should not be overly perturbed by the effects of increasing rates. This is because this caliber of investors will continue receiving interests up and until the maturity date, at which instance an investor can redeem the initial value or in market terms the face value of the purchased bonds (Maxey, 2015).

The market for bonds is obviously an extremely active one, as interest rates continuously react to various factors that encompass changes in regards to credit supply as well as demand fiscal policy, Federal Reserve policy, market psychology, economic conditions and most importantly anticipations regarding inflation (Securities Exchnage Commission, 2015). At present, soaring interest rates coupled with economic recovery expectations are indeed impact bond markets fundamentally.  The relationship between interest rates and bonds is an inverse where the value of all bonds issued within the market changes disproportionately as interest increase and vice versa (Market Watch, 2015).  Anyone who is considering investing in bonds or has recently bought the same, it is important to be appraised about the impacts of increasing interest rates on ones holdings. On this background, this submission will therefore seek to critically analyze the relationship between rising interests and the value of bonds given current market conditions.

How Rising Interest Rate Affect Bonds

With regard investments designed to generate fixed income, there are diverse choices to this end. Each market segment, nonetheless responds differently to variations in interest rates, economic outlooks as well as other market dynamics (Maxey, 2015).  At a glance, the inversely proportional relationship that exists between interest rates and bond values might appear rather illogical. However, upon further scrutiny of this linkage, one starts to realize the rationale behind the relationship. Towards this end, it is important to first gain an understanding of the potential returns from bonds by considering the effect of interest rate on the same. The yield in this regard can be considered as the return generated by “fixed income investment” and in respect to bonds, it is based on the interest as well as the buying price. Yield is basically the terminology employed to designate “long-term interest rates” (Patton, 2013). The yield is calculated as follows:

Yield= coupon/Bond Purchase Price

Fundamentals of Bonds and Increasing Interest Rates

            A basic norm of investing in bonds is predicated on the understanding that bond values are driven by prices-when there is an increase in interest rates, the value of current bond declines. More precisely, as these rates escalate, the value of bonds must produce a corresponding reduction so that attract potential bond buyers through reduced interest payments (Securities Exchnage Commission, 2015). Take for instance an individual who bought a bought valued at $ 100 with a 4% yearly bond (coupon rate) but the yield in terms of quality and maturity has increased to 5%. This then means that if the individual decides to sell, no one will be willing to pay the initial value of $ 100to acquire a 4% return  when it is possible to 25% more in terms of yields. This implies that the seller must make bond correspondingly attractive by lowering the price (Market Watch, 2015).

Although this inverse relation is a fundamental tenet of “fixed-income investment” the impact on dynamic rates depends upon the type of security purchased (Bank of America, 2015). For instance, shorter maturity bonds or bonds underlined by fewer years before repayment are slightly affected by increasing interest rates as opposed to longer-term bonds. This is due to the fact that the holders of such securities will recoup their initial investment and associated interest sooner than the former and as such can re-invest their earnings under new interest rates (Patton, 2013). Moreover, lower-quality bonds, which are essentially issued by organizations with inferior credit ratings, are more susceptible to risks inherent to credit. In other words, their values will be impacted negatively by increases in interest rates as well as other economic conditions notes Maxey (2015).

Bond Maturity and Total Return

            In order to understand the effect of increasing interest rates, it is important to considered what bond maturity means. As previously stated, bonds with lengthy maturity periods are highly susceptible to increasing rates due to the fact that new; higher rates are applicable over a lengthy period. This then means that shorter maturity bonds are will be affected to a lesser degree by rising rates (Bank of America, 2015).

The measurement of the maturity as calculated by bond experts indicates that bonds or else bond funds are highly sensitive to vertical movements of interest rates in whichever  direction –increases in interest rates will result in a corresponding downward reduction in bond values and the reverse is true (Securities Exchnage Commission, 2015).  This avails the a rough estimation of as to the precise point within the maturity period as to how bond prices react to changes say 1% in anticipated yields.  The implication here is that longer the maturity period, the more the value of bonds will decrease in the event of increasing interest rates.  Conversely, lower maturity duration will not affect bond price when rates drop (Bank of America, 2015).  This can be understood by considering the following example:

If the selling price of a zero-coupon rate is say $ 900 with a “par value” of $ 900 (one year maturity) the rate of return for this particular bond considering present time is roughly 5.56% ((1000-950) / 900 = 5.56%). This implies that any buyer willing to part with $900 for the said bond he/she is satisfied with a 5.56% return on the investment.  However the satisfaction is contingent upon on the conditions underlying the bond market at a particular point. The essence of investing in this type of security is to gain the best possible return and therefore in the event of rises in existing interest rates, resulting in a 10% rise in freshly issued bonds, the implication is that the “zero-coupon bond” with a projected 5.56% yield will become less attractive and consequently the fall or there would be no demand at all. The question that begs is which investor would be satisfied with purchasing the 5.56% bond when the market is offering 10% returns?  In order to attract and sustain demand, the value of pre-existing “zero-coupon bonds” must decrease significantly in order to match an equal return determined by existing interest rates (Lynchburg Business, 2015).

As a cardinal rule in securities trading, every one percentage point increase in interest rates results in a corresponding loss (1%) of the bond value for each year during the maturity duration (Bank of America, 2015). This means that if interest rates rise by 1%, then a bond with a maturity period of 5 years would decrease in value by 5%. Contrariwise, if the rates fall by 1% the five year bond would appreciate in value by a further 5%. This also indicates that the longer the maturity period, the greater the effect of increased interest rates will portend for prices of bonds as well as bond funds and hence the higher risk presented by interest rates. The main point in this regard is that the yield (interest rate) of a particular bond will increase when the bond declines in value. In other words, when an increase in interest rates effectively mean that bond value will generally decline and it is for this reason that yield are regarded as unfavorable for existing investors (Securities Exchnage Commission, 2015).

When considering the effect of interest rates vi-sa-vi the maturity period, it is important to examine the effect of rising rates on different bonds (Bank of America, 2015). More specifically, do interest rates affect all bonds in the same manner?  The answer to this important question is to the negative. In other words, rising rates do not affect all bonds equally. From a generally perspective, the length of the maturity period determines the impact upward variations will have on bonds. For instance, a bond with a maturity period of ten  years will have  loss a cumulative ten percentage points should inter rates soar by an annual rate of 1%. Conversely, a bond with two years maturity rate will decrease in value by 2% if the rate increases by an annual rate of 1%.  Further, it is important to note that the lower the coupon rate is for a particular rate, the more sensitive the security is to upward interest rates variations (Bank of America, 2015).

Figure 1: effects of interest rates on total return

Source: Own Edit

Any increases in interest rates affect the overall on investment in fixed-income securities these coupled bond yields are critical factors when considering when to buy bonds (Market Watch, 2015). This therefore means that the most important factor to watch in this regard is the total return to be accrued from bond and/or bond funds.  This entails the amount the body has accrued to the investor in terms of interest over a given period (bond yield) in addition to any capital gains or else gains as a result of rising rates at during the sale of the bond. In essence, this is indicative of entire amount gained or else lost through a bond or bond funds when they are finally sold (Securities Exchnage Commission, 2015).

Rising Interest Rates and Bond Funds

            Given the current escalation of interest rates, shareholders in bond funds are more affected by these changes than individual bond holders since a particular bond fund will hundreds or even thousands of distinctive bonds (Bank of America, 2015). In situations where interest rates increase, shareholders will be forced to liquidate their stakes. When this takes place, the fund managers may have no option but to sell the bonds in a premature manner with a view to raising adequate cash to adequately satisfy the numerous redemption requests.  Such a move will have destructive implications on the “Net Asset Value” (NAV) notes the (Securities Exchnage Commission, (2015).

Towards this end, it is evident that bond funds are characterized by additional risks during periods underlined by increases in interest in a situation known by market terminologies as the redemption risk. This type of risk amplifies the risk portended by rising rates for those who elect to remain in the said bond fund. For individual bond holders, this risk does not apply as regardless of changes in interest rates, the bond will mature and the investor will receive the par value or the original value in its entirety (Patton, 2013).

Implications for Investors

            How individual investors or institutional investors manage respect fixed-income securities when there is an increase in interest rates depends upon on the type of securities and the reasons for investing in them (Patton, 2013). In the event of unforeseen augmentation of interest rates, it is important for investors to engage their investment advisers or advisers, particularly for individuals or institutions holding significant positions in regards to bond funds.   There are however a number of strategies that investors in fixed-asset securities and in this case can leverage to reducing the effect of increasing interest rates. To begin with, diversification is critical to this end. In this regard, it is important for investors to appreciate that fixed-income securities form the core facet of any diversified portfolio. Due to their ability to respond varyingly to prevailing market conditions as opposed to equities, any allocation to bon funds or else bonds can result in an incremental income on the one hand, while moderating general portfolio risk (Bank of America, 2015).

This is a call to bond investors to consider diversification given the current level of interest rates as this portends the greatest benefits and minimal risks.  A good example of this is the United States Treasury securities. They are ideal under present as they accurately react varyingly to prevailing market conditions with limited or uniform correlations to equities (Securities Exchnage Commission, 2015).

Secondly, investors can safeguard investors against potential unconstructive effects presented by increasing interest rates by simply incorporating a “fixed ladder” into their overall portfolio (Maxey, 2015). This can be achieved through by buying fixed-income investments such as municipal and corporate bonds with varying maturity periods. With this ladder properly integrated into the investment portfolio, a portion of the same will mature at consistent intervals   consequently benefiting the investor in the event of any augmentation of interest rates through re-investing the returns from matured bonds at an elevated rate (Lynchburg Business, 2015). Responding to volatilities in bond values by investing a broad portfolio of fixed-income securities does not only lead to better returns but are also less affected by changes introduced  by the Federal Reserve’s Policy as well as increasing interest rates.  This informs the rationale for investing in a blend of bond with different maturity dates as well as different forms of the same. This approach is particularly applicable to bond funds as is a proven stratagem for reducing the level of risk within a diversified portfolio in addition to reducing the net effects of soaring rates (Securities Exchnage Commission, 2015).

In addition, owning bonds through a mutual fund is an effective way addressing the risks portended by increasing interest rates. This is predicated on the understanding that within a market environment underlined by rising rates, buying bonds through a “fixed-income fund” managed in an active manner as opposed to individual bonds is advantageous given the fact that the person charged with the responsibility of managing the funds monitors variations in interest rates on a continuous basis. As such, he/she is a position to make appropriate decisions in regards to purchase or sales of the securities on the fund’s shareholders behalf (Bank of America, 2015).

Finally, reducing the maturity duration in regards to bond funds and individual bondholders can effectively reduce the effects of increasing interest rates.  This can be achieved through shifting the exposure of a portfolio to blend of bonds as well as funds underlined by fixed shorter maturity periods especially where the investment portfolio is  comprised principally of bonds with long-term maturity durations (Lynchburg Business, 2015).


This submission has critically analyzed the relationship between rising interests and the value of bonds given current market conditions based on the understanding that market for bonds as presently constituted is an extremely active one, as interest rates continuously react to various factors that encompass changes in regards to credit supply as well as demand fiscal policy, Federal Reserve policy, market psychology, economic conditions and most importantly anticipations regarding inflation. At present, soaring interest rates coupled with economic recovery expectations are indeed impact bond markets fundamentally.  The  exercise has since established that relationship between interest rates and bonds is an inverse where the value of all bonds issued within the market changes disproportionately as interest increase and vice versa. Based on the noted impact of increasing impacts of interest on the overall return a bond can generate it is important to consider a number of options for reducing this impact. These include diversified portfolios, investing in bonds through mutual funds, fixed ladder portfolios and reducing or varying the duration period.  The paper has also noted that the effect of increasing interest rates is most profound in short-term bonds as opposed to bonds-with long-term maturity periods. Therefore, those holding or planning to hold bonds until they mature should not be overly concerned by the effects of increasing rates and associated Federal reserve policy as well as fiscal policy in regards to the same.  Long-term investors are thus at an advantage as they will continue receiving interests up and until the maturity date, at which instance an investor can redeem the initial value/ face value of the purchased bonds.



Bank of America. (2015, April). How to manage your fixed-income investments when interest rates rise. Retrieved from Bank of America: http://ME_FixedIncome_RisingRates_TopicPaper.pdf

Lynchburg Business. (2015, April). How Should You Respond to Higher Interest Rates? Retrieved from Lynchburg Business:

Market Watch. (2015, April). Your bond funds will do this when interest rates rise . Retrieved from MarketWatch:

Maxey, D. (2015). What Happens to Your Bond Fund When Interest Rates Rise. Retrieved from Wallstreet Journal:

Patton, M. (2013, August 30th). Why Rising Interest Rates Are Bad For Bonds And What You Can Do About It. Retrieved from Forbes:

Securities Exchnage Commission. (2015). Investors Bulletin: Interest rate risk -When Interest rates Go up, Prices of Fixed-rate Bonds Fall. Retrieved from Securities Exchnage Commission:


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