Why does a bond lose value when interest rates rise?Start here

Nobody will pay full price for last year's interest rate when this year's is higher. The discount is the whole mechanism.

A bond pays a fixed amount of interest. That is the entire reason. The coupon was set on the day it was issued and it never changes, so when the world's interest rate moves, the only thing left that can move is the price.

What actually happens, step by step?

Say you own a bond that pays 2% a year and repays 100 in five years. Rates rise, and new bonds now pay 4%. Your bond still pays 2. Nobody will buy it at 100, because they can get 4 elsewhere for the same money.

So the price falls until the deal is equal. Buy your bond at about 91 and you collect 2 a year plus the 9 you gain when it repays 100 at the end. Add those together and it works out at roughly 4% a year — the same as the new bond. The market did not decide your bond was worse. It repriced it until it was competitive.

The reverse works identically. If rates fall to 1%, your 2% bond is the better deal and its price rises until it isn't.

How far does it fall? That is duration.

The answer is not a mystery, and it has a name. Duration measures how long you wait, on average, for the bond's money — weighted by how much arrives when. A rough rule follows from it: price change ≈ minus duration times the change in yield.

A bond with duration 5 loses about 5% when yields rise by one percentage point. Duration 15 loses about 15%. That is why long bonds are the ones that get hurt, and why 2022 was so painful for portfolios that were meant to be the safe half: yields rose several points, and 20-year government bonds fell more than 30%.

The government bond page has the calculator, and it is worth putting your own numbers into.

If I hold to maturity, do I lose anything?

You get 100 back, and you get every coupon in between. That is contractual and the price along the way did not change it. In that narrow sense: no.

But you did lose something real. For five years your money earned 2% while it could have earned 4%. That gap is exactly what the price drop measured on day one. The paper loss and the missed income are two views of the same thing, not two different things.

Then why does anyone say bonds are safe?

Because "safe" is being used for two different risks. A government bond in your own currency is safe from the borrower not paying: that is credit risk, and it is close to zero. It is not safe from interest rates moving: that is rate risk, and it never goes away.

Both are real. A bond fund holding safe government debt can fall 15% in a year without a single borrower missing a payment. Nothing went wrong. Rates moved.

Does a bond fund behave differently from a bond?

Yes, in one way that matters. An individual bond has a maturity date, so if you wait long enough you get your 100. A fund usually keeps a target duration and sells bonds as they get short, so there is no date at which the fund promises you anything. It carries rate risk permanently.

Neither is better. They fit different plans, and individual bonds versus bond funds is the page that lays out which is which.

What is the practical takeaway?

• Look up the duration of what you own. It is on every factsheet.
• Multiply it by the rate move you think is possible. That is roughly the loss.
• Ask whether you can wait that long. If you can, rate risk is mostly noise. If you cannot, it is the main risk you hold.