Why Bond Prices Go Up and Down

Step 2: Can I Protect Myself Against Interest Rate Fluctuations?

What can you do to protect your money against interest rate fluctuations?

The best protection is to buy bonds with maturities that are either short (under one year) or short-intermediate (between two and seven years).

While all bonds are subject to interest rate risk, that risk is correlated to maturity length. As maturity length increases, so do potential price fluctuations. Conversely, the shorter the maturity of the bond you buy, the lower the risk of price fluctuations as a result of changes in interest rate levels.

To illustrate, let's look at Table 1. This table shows what would happen to the price of a bond selling at par ($1,000), with a 7% coupon, for several different maturities, under three different scenarios:

• Interest rates rise modestly by 50 basis points, to 7.5%;
• Interest rates rise by 100 basis points, to 8%;
• Interest rates rise steeply, by 200 basis points, to 9%.

Table 1 shows that if interest rates rise modestly, by 50 basis points, the price of the two-year bond changes very little. But even that modest rise results in a decline of 3.5% ($35) for the 10-year bond and 5.9% ($59) for the 30-year bond. For the 30-year bond, the decline of 5.9% wipes out almost the total amount of interest income for the entire year. If a much sharper rise in interest rates occurs, from 7% to 9%, declines become correspondingly larger. Clearly, if interest rates go up, the holder of bonds with shorter maturities would be less unhappy than the holder of bonds with long maturities.

Table 1. Interest Rate Risk: Bond Price Changes if Interest Rates Rise)
($1,000 par value bond with a 7% coupon)

This phenomenon, happily, operates in reverse. As interest rates decline, bond prices rise. This is illustrated in Table 2, which shows changes in price for various maturities under three declining interest rate scenarios. Once again, the change in price is much smaller for the two-year maturity, but it rises gradually through the maturity spectrum. In this instance, the holder of a bond would benefit from holding the longest maturities because the longer the maturity, the higher the gain. That is the reason that investors anticipating a decline in interest rates position themselves at the long end of the maturity spectrum, in order to realize the largest capital gains.

Table 2. Interest Rate Risk: Bond Price Changes If Interest Rates Fall
($1,000 par value bond with a 7% coupon)

Several qualifications need to be made concerning both of these tables. First, the exact price changes illustrated are assumed to have occurred as a result of instantaneous changes in yield. In practice, such changes may take weeks, months, or even years. Changes occurring over longer time periods would result in somewhat different numbers because, as noted earlier, the price of a bond moves toward par as it gets closer to maturity, and those price changes occur regardless of what happens to interest rates.

Secondly, the exact price changes illustrated apply only to bonds selling at par, with a 7% coupon. The numbers would be different for bonds with coupons that are either higher or lower. Price changes would be somewhat larger, in both directions, if the coupons were lower than 7%, and the price changes would be lower if the coupons were somewhat higher than 7%.

Thirdly, if you look at the price changes that occur in both directions, you will note that these changes are not linear. If interest rates rise, the price of a bond declines as maturity length increases, but those increases occur at a declining rate. That decline in the rate of increase begins to be noticeable approximately after the 10-year mark. Similarly, if interest rates decline, the price of bonds increases as maturity length increases, but again, at a declining rate that begins to be noticeable at the approximate 10-year mark. Nonetheless, it remains the case that price changes are greatest at the highest maturity length.

Finally, note that the price changes that occur if interest rates move up or down are somewhat larger if interest rates decline than if they go up. For example, for the 30-year bond, if interest rates go up by 100 basis points, the price of the bond declines by 11.3%. But if interest rates decline by 100 basis points, the price of the same bond goes up by 13.8%. Similarly, if interest rates go up by 200 basis points, the price of the 30-year bond declines by 20.6%. But if interest rates decline, the price of the same bond goes up by 30.9%. That distinction is obviously a desirable characteristic: Your bond appreciates more in value if interest rates decline than it loses if interest rates rise. This characteristic has a somewhat formidable name: It is known as convexity.

In summary, while the numbers vary somewhat for different bonds, both Table 1 and Table 2 illustrate two basic principles. First, the prices of bonds and interest rates move in opposite directions. If interest rates decline, the price of a bond goes up, and if interest rates rise, the price of a bond declines. Second, bonds with longer maturities incur significantly higher interest rate risk than those with shorter maturities. That is a disadvantage if interest rates rise, but an advantage if interest rates decline.

So now we have the two faces of interest rate fluctuations: risk and opportunity. It may sound paradoxical, but a rising or strong bond market is one in which interest rates are declining because that causes bond prices to rise. You can sell a bond for more than you paid for it and make a profit. A weak bond market is one in which interest rates are rising and, as a result, prices are falling. If you have to sell your bonds, you have to do so at a loss. In either case, the changes in price are correlated to maturity length.

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