Understanding Bonds and Interest Rate Risk

What Are Bonds?

A bond is essentially a loan. When you buy a bond, you are lending money to the issuer — whether that is the U.S. Treasury, a state or local government, or a corporation — in exchange for two things: regular interest payments (called coupon payments) during the life of the bond, and the return of your original investment (the face value or par value) when the bond reaches its maturity date.

Bonds are often referred to as "fixed income" investments because most bonds pay a fixed rate of interest on a predictable schedule. This steady income stream is one of the primary reasons investors include bonds in their portfolios. Unlike stocks, which offer no guaranteed return and can fluctuate dramatically in the short term, bonds provide a contractual obligation to pay interest and return principal, making them generally less volatile than equities.

However, "less volatile" does not mean risk-free. Bonds carry their own set of risks, with interest rate risk and credit risk being the two most important. Understanding these risks is essential for any investor who holds bonds or is considering adding them to their portfolio.

Key Bond Terms

Before diving deeper, it helps to understand the core terminology that applies to all bonds.

Face Value (Par Value). The amount the bond issuer agrees to repay when the bond matures, typically $1,000 per bond. This is the principal of your loan.

Coupon Rate. The annual interest rate the bond pays, expressed as a percentage of face value. A bond with a $1,000 face value and a 4% coupon rate pays $40 per year in interest.

Maturity. The date on which the bond issuer returns the face value to the bondholder. Bond maturities can range from a few months (Treasury bills) to 30 years or more.

Yield. The effective return you earn on a bond based on its current market price. If you buy a bond at a discount to face value, your yield will be higher than the coupon rate. If you buy at a premium, your yield will be lower.

Duration. A measure of a bond's sensitivity to changes in interest rates, expressed in years. The higher the duration, the more the bond's price will move when interest rates change. Duration accounts for the timing and size of all cash flows (coupon payments and principal return) to produce a single number that estimates price sensitivity.

How Bond Prices and Interest Rates Are Related

The most important concept in bond investing is the inverse relationship between bond prices and interest rates. When interest rates rise, existing bond prices fall. When interest rates fall, existing bond prices rise. This relationship is mathematical and inescapable.

The logic is straightforward. Suppose you hold a bond paying a 3% coupon. If newly issued bonds begin paying 4%, your 3% bond becomes less attractive to buyers — why would they pay full price for your bond when they can buy a new one that pays more? To compensate, the market price of your bond falls until its effective yield matches what new bonds are offering. The reverse is also true: if new bonds are only paying 2%, your 3% bond becomes more valuable, and its price rises.

Types of Bonds

Bonds come in several varieties, each with distinct characteristics in terms of risk, return, and tax treatment. The table below compares the four most common types.

U.S. Treasury bonds are considered the safest bonds in the world because they are backed by the full taxing power of the federal government. Municipal bonds offer attractive tax advantages, particularly for investors in higher tax brackets. Investment-grade corporate bonds offer higher yields than Treasuries in exchange for accepting some credit risk. High-yield (or "junk") bonds offer the highest yields but also the greatest risk of default.

Duration and Interest Rate Sensitivity

Duration is the single most important number for understanding how much a bond's price will change when interest rates move. As a general rule of thumb, for every 1% increase in interest rates, a bond's price will fall by approximately the same percentage as its duration (in years). The table below illustrates this relationship.

A bond with a 2-year duration will lose roughly 2% of its value if interest rates rise by 1 percentage point. That same rate increase would cause a 20-year duration bond to lose approximately 20% of its value. This is why long-duration bonds are significantly more volatile than short-duration bonds. Investors who need stability and capital preservation should generally favor shorter-duration bonds, while those with longer time horizons may be willing to accept the greater price volatility of longer-duration bonds in exchange for typically higher yields.

The Role of Bonds in a Portfolio

Bonds serve several critical functions in a well-constructed investment portfolio. They provide ballast during stock market downturns, generate regular income, and reduce overall portfolio volatility. Historically, bonds have had a low or even negative correlation with stocks, meaning they often hold their value or appreciate when equities decline.

The classic 60/40 portfolio (60% stocks, 40% bonds) has historically delivered roughly 80% of the stock market's return with significantly less volatility. For investors approaching or in retirement, the reduced volatility can be the difference between a sustainable withdrawal plan and one that is derailed by a poorly timed market downturn. Even younger investors benefit from holding some bonds, as the portfolio stability they provide makes it easier to stay invested during turbulent periods.

Bond Laddering Strategy

Bond laddering is a strategy where you purchase bonds with staggered maturity dates — for example, bonds maturing in one, two, three, four, and five years. As each bond matures, you reinvest the proceeds into a new bond at the longest rung of the ladder. This approach provides several advantages: it generates regular cash flow as bonds mature at different intervals, reduces interest rate risk by spreading purchases across different rate environments, and avoids the need to predict whether rates will rise or fall.

A bond ladder is particularly useful for retirees who need predictable income. By matching bond maturities to anticipated spending needs, you create a reliable source of funds without being forced to sell bonds at an inopportune time. If rates rise, your maturing bonds can be reinvested at the new, higher rates. If rates fall, your longer-dated bonds locked in the higher rates from when they were purchased.

Navigating the Current Rate Environment

After a historic period of near-zero interest rates that lasted for much of the decade following the 2008 financial crisis, the Federal Reserve raised rates aggressively in 2022 and 2023 to combat inflation. This rapid rate increase caused significant losses in bond portfolios, particularly those with longer durations. However, the silver lining is that bonds now offer meaningfully higher yields than they have in over a decade, making them a more attractive component of a diversified portfolio going forward.

For new money being invested in bonds today, higher rates are unambiguously positive — you are lending your money at a higher interest rate and will receive more income over time. For existing bond holdings that declined in value when rates rose, patience is key: as those bonds approach their maturity dates, their prices will converge back toward face value, and in the meantime, you continue to collect the coupon payments.

This article is for informational purposes only and does not constitute investment advice. All information should be discussed with a qualified financial advisor before implementation.