Rising bond yields: what happens to bonds when interest rates rise

Bonds and especially gilts have taken a hellavua beating recently. Rising bond yields have inflicted losses shocking enough to put some people off for life. And that’s a shame because bonds and equities share an important characteristic: they’re likely to be more profitable in the future after a sharp price fall than after a gain. To explain why, let’s investigate what happens to bonds when interest rates rise. 

When interest rates rise, two things typically happen to older bonds1:

• The yield on the bonds rise 

• The price of the bonds fall

This means that as interest rates rise, your bond portfolio or fund will probably suffer a capital loss.

And lower prices for bonds mean your fund is worth less, right? 

Right. But counterintuitively, interest rate rises also create the conditions for stronger bond returns in the future. 

That’s because rising bond yields equate to higher future income payments.

Eventually those improved cashflows can reverse your capital losses and then put you further ahead than if the interest rate rise had never happened. 

Rising bond yields: are they good or bad?

Rising bond yields are bad news at first because they trigger capital losses. But the good news is your expected bond returns are actually greater after a rate rise.

This example shows three alternate destinies for the same intermediate bond fund – depending on the future path of interest rates: 

Source: Author’s calculations and Portfolio Charts

This is a necessarily simplified example that doesn’t include daily fluctuations in yield, nor investment costs. We have assumed an upward sloping yield curve that shifts in parallel, and that all interest is reinvested. The underlying bond fund calculations are handled by Portfolio Charts’ excellent bond index calculator.

• The blue timeline shows what unfolds when interest rates hike 2% and then remain stable. Despite an initial double-digit capital loss the fund earns a 4.5% annualised return over 15 years.  

• The green timeline tracks the bond fund’s fate if interest rates stay flat. It earns a 3.8% annualised return in this scenario. 

• Finally, the red timeline charts a cork-popping 22% initial gain triggered by a 2% interest rate drop. But rates then go flat like cheap fizz. The fund limps home with a 3.1% annualised return.

Hence the surprising result is that the rising yield scenario is the most profitable one over the long term. 

It’s like a bond fund morality tale. Good things come to those who wait.

Who said bonds were boring?

Long-term investors reeling from recent reverses in their bond funds could imagine it as a hero’s journey:

• First, the setback as the interest rate rise inflicts calamitous losses. 

• Then the transformation as stronger cashflows bend the arc of fortune upwards.  

• Atonement as the blue bond fund overtakes its lazier selves enjoying the easy life. 

• Finally the triumphant return: 4.5% annualised in this case. 

You’ll notice it takes the rising yield scenario fund more than three years to recover its capital loss. And it’s ten years until it’s more profitable than if yields hadn’t risen.

But it’s returned 22% more than its falling yield ‘alternative reality’ self after 15 years. 

If you owned a shorter-term bond fund it would recover more quickly. The trade-off is its annualised returns would be lower. 

Conversely a longer bond fund takes more time to repair the damage but annualised returns would be higher still. 

Either way the pattern is the same. 

Yet if you asked most people, I’d wager that they’re cursing rising bond yields right now. 

It’s like an adult version of the marshmallow test. Do you want a quick sugary hit or can you wait for a bigger payoff?

What happens to bonds when interest rates rise?

In a nutshell, rising interest rates in 2022 have caused our existing bonds to be marked down in price. Hence the capital losses. 

But our existing bonds get replaced by higher-yielding versions as they reach maturity. And the new bonds pay more income. 

Over time, the replacements produce a stronger stream of cashflows. This erases the earlier losses. 

It’s like a heavy snowfall that covers a pothole. After a while the snow piles up until you’re left with a big mound. The tear in the road is long since forgotten. 

But to properly understand the underlying mechanism we need to clear something up.

The interest rates that directly affect bond prices are not the Bank Of England’s interest rates. Or any other central bank’s rate. 

No, bonds respond like a puppet on a string to market interest rates. 

Market interest rates are the sum of supply and demand for any given bond. 

Which means each bond has its own interest rate. And that rate yo-yos in tune with bond traders’ views on:

• The bond’s specific properties, such as its credit rating and maturity date.

• Broader forces – inflation, the state of the economy, currency moves, animal spirits and, yes, the influence of central bank interest rates. 

Ultimately, the market interest rate is the return that investor’s demand for bearing the risk of holding a particular bond.  

Why do bond prices fall when interest rates rise?

The reason that bond prices fall when interest rates rise is so that older, lower income bonds remain competitive against newer equivalents that pay better rates. 

Why does this happen?

Well, it’s because most newly-issued bonds pay a steady stream of income that match the prevailing interest rate for their type.  

For example, if the market interest rate for a ten-year gilt is 4%, then a freshly printed 10-year gilt must pony up a 4% annual income stream to be competitive. 

If it didn’t then nobody would buy it. (And then the government wouldn’t be able to finance all those national nice-to-haves like roads, schools, hospitals, the army and such like.)

That fixed rate of bond interest is formally called a coupon rate. 

For example, a bond with a 4% coupon pays £4 per year on its principal of £100.2

The £100 principal is the amount loaned to the government in the first place, when the bond is issued. When the bond matures, whoever owns it at that point will get that £100 back.

But what if interest rates for ten-year gilts afterwards rise to 5%? Then now our old 4% job looks like an Austin Allegro in a car park full of Teslas.

You’re worried about being laughed off the bond trader’s floor with your weeny debt instrument. 

You want to get shot of the 4% gilt. But why would anyone buy it when they can get a shiny, new version of the same thing paying 5%?

There can only be one answer: you sell it at a discount. A lower price that recognises that 4% bonds aren’t all that when 5% behemoths roam the bond market. 

The discount price needed to sell this bond is: £92.21

Bazinga! At that new price your 4% ten-year gilt offers exactly the same return as a 5% ten-year gilt worth £100. 

This market reality explains why bond prices fall when interest rates rise.

Brief sci-fi side trip to an alternative universe

If prices didn’t drop, then nobody would be able to offload their less competitive bonds when a factor like inflation spurs everyone to demand higher rates of interest. 

And if prices didn’t adjust like that, then the bond market wouldn’t function properly.

Instead it’d be like a vast hodgepodge of fixed-rate and fixed-term savings accounts. All sporting different interest rates, depending on when they were initiated.

There would be no liquidity. The fixed term would lock you into your ‘savings account’ with a particular tranche of government debt until it matured.

Government financing would be far more expensive. The risk of being locked into lower interest rates would make everyone demand much higher coupons in the first place.

Basically, if today’s government bond market didn’t exist then somebody would have to invent it.

Rates up, price down, rates down, price up

Back in the real world, the same phenomenon of a bond’s price and yield adjusting to prevailing rates works in reverse. 

If market interest rates fell from 4% to 3%, say, then your old gilt with its 4% coupon would look good by comparison. 

Some quick sums reveal you’d be able to sell it for £108.58. (In practice a small investor wouldn’t need to do any maths. The market constantly adjusts pricing across all bonds as rates move).

At the higher price, your 4% ten-year gilt offers exactly the same return as a 3% ten-year gilt priced at £100. 

From this market-clearing mechanism we can derive the iron law of bonds:

• When interest rates rise, the price of a bond falls.

• When interest rates fall, the price of a bond rises.

You can check out the price changes yourself using a bond price calculator.

Rising bond yields: which yield are they talking about? 

Yield-to-maturity (YTM) is the metric that really counts. 

YTM (minus costs) is a bond’s expected annualised return if you hold it to maturity. This yield takes into account the bond’s current price, and assumes all remaining coupon payments are reinvested at the same interest rate.

Yield-to-maturity is the critical metric enabling you to compare the expected return of bonds of a similar type, even though they vary by price, maturity, and coupon.

Whenever we talk about bond yields in this post we’re referring to the yield-to-maturity.

With this metric in play, we can finally get to the heart of why bond prices fall when interest rates rise. 

In the example above, our poor old gilt – saddled with its now-underwhelming 4% coupon – was outgunned by new-fangled gilts spraying about 5% per year. 

Our 4% gilt’s price falls to £92.21, which pushes up its YTM to 5%. Now it offers a 5% annualised return to new buyers and is every bit as appealing as its newer rival. 

Extra yield juice, reinvested, is on top of the £7.79 capital gain a buyer will make if they hold the 4% gilt to maturity. On that date the bondholder receives the £100 principal payment, booking a £7.79 gain over the price they bought it for.  

Hence it’s the discounted price that enables an old bond with an under-powered coupon to trade on equal terms with new entrants on the market.   

Again, the process plays out in reverse when interest rates fall. Which brings us to the second iron law of bonds:

• Yields rise when the price of a bond falls.

• Yields fall when the price of a bond rises.

Higher market interest rates means investors are demanding a higher yield (i.e. a greater return) on their money. 

And as we saw in our sci-fi aside earlier, this price-adjustment mechanism is what prevents the bond market seizing up due to it saddling investors with uncompetitive bonds they need to sell. 

Not so smooth operators

In reality bond investors constantly reevaluate their assumptions just as equity investors do.

Thus market interest rates oscillate like a thrash metal guitar string. Which causes bond yields to rise and fall like empires on fast-forward, and prices to seesaw like frenzied toddlers.  

Thus, while my chart above models the effect of rising bond yields in principle, the real world is far messier. Interest rates are never going to hike on day one then stay flat for the next 15 years.

So how can we apply the rules above to our own investments?

Rising bond yield takeaways

Let’s boil down all this bond banter to some basic principals you can take to the bank.

Rising bond yields are positive for long-term investors who can ride out the capital losses and eventually take advantage of fatter income payments. 

Much of the doom and gloom after the Financial Crisis concerned the fact that low yields meant miserly long-term bond returns. It dragged down the equity risk premium as well.

Now, rising rates and a return to the old normal is leaving that particular threat in the rear-view mirror. 

Higher coupons should lower bond volatility. They plump up your safety cushion against equity losses, too. 

But let’s be clear-eyed about the risks.

Sharply rising bond yields can rain pain upon us for years. This happened to UK government bonds in the 1970s. 

Eventually those vertiginous yields became the source of stellar bond returns in the 1980s and 1990s when high inflation and interest rates fell away. 

But a rising rate environment is no picnic if you’re short on time. You’ll lock in real capital losses if you’re a forced seller, before your bond allocation can take advantage of higher yields. 

If you need to sell to pay the bills then some of your allocation should be in cash and short duration bonds. These refuges are less vulnerable to inflation and less sensitive to interest rate moves. 

The standard advice is to match your bond fund’s duration to your time horizon. 

But this is tricky to do in practice and is no magic bullet anyway. We’ll talk it through in a follow-up post. 

The other important point is that not all interest rate rises are as calamitous as the surges that heaped historic havoc on the UK recently. 

Steep and rapid hikes at the long end of the yield curve can ravage bonds with lengthy lifespans.

Gentle climbs over years are much easier to cope with. 

What you should do about bonds

That brings us finally to the psychological element.

You may be a long-term investor who can afford to wait for rising bond yields to work their charm. 

But if staring at a long bond fund in the red for years on end is going to gnaw at your psyche then the waiting game may not be for you. 

We know that high inflation which escapes its Central Bank gatekeepers is bad for bonds. 

So it’s not hard to imagine a world where bond yields could keep rising from here.

If that higher-than-expected inflation scenario unfolds then we’ll spend much longer eating capital losses before finally enjoying the fruits of growing yields. 

To me, that has suggested trimming bond allocations, looking at diversification options, and reassessing your exposure to long bonds. I argued for that in a reappraisal of the 60/40 portfolio.

But I believe it’s short-sighted to ditch bonds entirely.  

We do not know that interest rates will keep rising. 

In a deep recession they typically fall – buffering your portfolio with bond capital gains even as equities crash like a drunk’s Jenga tower. 

In that scenario, your bond funds are likely to be the best comfort you’ve got. 

When do you think the next recession will be? Never? Soon? Anytime now?

Such uncertainty means there’s still a place for bonds.

Take it steady,

The Accumulator

P.S. I can’t find a better place to put this bit, but because bond funds sell their bonds before they mature, yield-to-maturity is a fuzzier measure with funds than with individual bonds. It is still a useful bond fund comparator and your best guide to future expected returns, but with a fund YTM is not a guarantee of any particular return.

P.P.S. Take a look at our best bond fund ideas for help with your research.

1. By ‘older bonds’ we mean previously issued bonds that trade on the secondary market. We don’t mean newly issued bonds. [↩]
2. A bond’s principal is also called par value, nominal value, or face value. Essentially it’s the original value of the loan made to the bond issuer. [↩]