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Bonds and Interest Rates: Why Prices Move in Opposite Directions
Key takeaways
- Bond price and yield always move in opposite directions — this is a mathematical law, not a coincidence.
- The longer the maturity, the more sensitive the bond is to rate changes (higher duration).
- In a rising-rate environment, short-term bonds offer better protection than long-term ones.
- Bonds in a portfolio dampen equity volatility — their added value is not only in the coupon.
- Investors should understand the duration of their bond ETF, not just its yield.
Bond price and yield always move in opposite directions — this is a fundamental mathematical law, not a market anomaly. Understanding this relationship is the key to any strategy that includes bonds.
Why Prices Fall When Rates Rise
Imagine a bond paying a fixed coupon. If the central bank raises rates, new buyers can purchase new bonds with a higher coupon. Your old bond with a lower coupon is suddenly less attractive — its price must fall so that its effective yield matches the new market rates. The price adjusts to keep the yield-to-maturity always market-competitive.
What Duration Is and Why It Matters
Duration expresses the average time it takes for a bond to return your invested money through coupons and principal repayment. The longer the duration, the more strongly the price reacts to rate changes. Short bonds (1–3 years) have low duration and are therefore more defensive in a rising-rate environment.
The Inverted Yield Curve
Normally, long-term yields are higher than short-term ones — the market compensates for longer risk. When the curve inverts (short-term yields exceed long-term yields), it is called an inverted yield curve. Historically, this has preceded numerous economic slowdowns.
Practical Implications for Investors
- Check the duration of your bond ETF in the prospectus or on the provider's website.
- Short-term bonds are suitable as a stabiliser in an uncertain rate environment.
- Bonds do not primarily serve to generate return — combined with equities, they reduce overall portfolio volatility.
If you are just building portfolio fundamentals, read how to build your first portfolio or look at the All World vs. S&P 500 comparison.
FAQ
Why do bond prices fall when rates rise?
Existing bonds with lower coupons become less attractive next to new ones offering higher coupons. For the old bond to remain competitive, its price falls. The yield-to-maturity thus "adjusts" to the market.
What is bond duration?
Duration expresses the sensitivity of a bond's price to changes in interest rates. A bond with a duration of 7 years will lose approximately 7% of its value when rates rise by 1 percentage point. Shorter duration means less sensitivity.
Do bonds make sense in my portfolio?
It depends on your goal and time horizon. Bonds primarily reduce overall portfolio volatility and act as a counterweight to equities. If you invest over 20+ years, their allocation may be low — but not zero.