You may think you’re a savvy investor. But have you ever put your knowledge to an actual test? There’s an ongoing national financial literacy study run by FINRA that you can take and review results at any time. The study has found that most Americans cannot correctly answer the following question: “If interest rates rise, what will typically happen to bond prices?”

Do you know the answer? If you had to look at the title to get it, we don’t hold it against you, because only 28% of Americans got this one right. That, of course, means 72% of people don’t realize bond prices generally fall when interest rates rise.

It’s important to understand the relationship between bond prices and interest rates so you can avoid being on the wrong side of the bond investment spectrum. The last thing you want is to watch the supposedly safer portion of your portfolio decline far more than you might have expected or thought possible.

Whether you own individual bonds, bond mutual funds, ETF’s, or have a portion of your 401(k), 403(b) or other qualified plans invested in bond investments, you will want to read on. If you didn’t know what happens to bond prices when interest rates rise, or you knew they fell but didn’t know why it’s time to increase your knowledge around these assets so you can make more informed investing decisions.

How Do Bonds Work?

Let’s first take a look at how bonds work. When you buy a bond, you effectively lend money to the issuer of that bond. The issuer agrees to pay you back in full at the bond’s predetermined maturity date.

In the meantime, the issuer will also pay you interest. Just as with any other loan, interest is the fee for borrowing the money and repaying it at a later date. The amount of interest is fixed at the time you purchase the bond (Unless you purchased what is known as a “floating rate” or “step- up” rate bond”). No matter what the market does, your interest rate is locked-in.

Here’s an example to illustrate how this works. Let’s say you purchase a 10-year, $1,000 bond with a fixed 5 percent interest rate. You would earn $50 in interest from the bond each year ($1,000 x 5 percent = $50).

You’ll earn a total of $500 in interest by the bond’s maturity date ($50 x 10 = $500). The issuer of the bond must also repay the amount they borrowed. At the end of the 10-year period, then you’d have $1,500 ($1,000 initial bond amount + $500 in interest).

Most bonds are pretty simple and straightforward — and relatively safe investments, but there are numerous types of bonds issued by a wide range of companies and government entities, all of which carry different levels of credit risk (risk of default) that you should understand.

What Causes Bond Prices to Fluctuate?

In addition to bonds being impacted by interest rates, which is discussed further below, bond prices are also impacted by a number of other factors, including an issuers credit rating which is determined by credit rating agencies (similar to how you as an individual have a credit score from FICO). The bond credit rating indicates how likely an issuer will be able to repay you as an investor, both in interest and for the original bond amount.

Better credit ratings usually equate to lower yields when you purchase bonds from these issuers as they’re more likely to repay the debt. That means you generally take less risk as an investor in bonds with strong credit ratings, but the tradeoff is they earn less interest than issuers with lower ratings.

If a bond you own has its credit rating reduced before it matures, its value will likely decline, thereby increasing their yield to compensate for the increased default risk.

In addition to credit ratings, inflation impacts bond prices too. Rising inflation means that the dollar you have today doesn’t buy as much as it did yesterday. Deflation would give you more buying power, making your dollar stronger.

Bond prices reflect this. When inflation rises, bond prices fall because what you’ll earn at maturity will be worth less due to a weaker dollar. And bond prices rise during periods of deflation because the amount earned at maturity is worth more.

Other factors that influence bond price include:

• The type of bond
• The time to maturity
• The frequency of interest payments

…and of course, there’s the matter of interest rates.

We know that bond prices increase when interest rates fall and bond prices decrease when interest rates rise. But why?

The Relationship between Bond Prices and Interest Rates

Think back to our example of how bonds work, when you bought a 10-year, $1,000 bond at 5 percent interest, called the “Coupon rate”. Let’s say you bought that last year — but now, one year later, interest rates are at 6 percent.

If you wanted to sell your bond, you’d have a hard time convincing a buyer to settle for receiving a 5 percent interest rate when they could buy a new bond that now pays a 6 percent interest rate. Remember, most bond’s interest rates don’t change over the life of the bond.

In order to entice someone to buy your 5% bond, you would need to sell your bond at a discount. How much of a discount typically depends on how long the new bondholder has to wait until the bond matures.

Here is a simplistic example of how that might work:

A potential buyer for your 5%, $1,000 face amount bond, with 9 years left to maturity, may only be willing to pay you $932, instead of the $1,000 you paid for it only a year ago.  Why? Because by paying you $932 versus the $1,000 price you paid, the new buyer will earn their desired 6% Yield to Maturity (9 years of $50 coupon payments, plus the $68 principal gain at the bonds maturity) that equates to a 6.8% drop in the value of your bond if you were to sell it rather than hold to maturity.

Duration

Duration is a measure of a bond or bond mutual fund or ETF’s sensitivity to rising interest rates, and is calculated based on the weighted average of the time period until a bond or bond portfolio’s interest and principal payments are received. The higher the duration number, the more sensitive your bonds will be to changes in interest rates, both up, and down.

A quick rule of thumb to use to determine your bond portfolios vulnerability in a rising rate environment is to start by determining your bond or bond mutual fund’s / ETF’s  duration (which can often be found on the mutual funds/ETF’s fact sheet or current research report). Generally speaking, a duration of 10 would mean for every 1% rise in interest rates your bond investments value would fall by 10%.  A duration of five (5) would equate to a 5% drop in value for each 1% rise in rates, and so on.  As you can see, the higher the duration, the higher the risk level of your bond holdings and vice versa.

In a rising rate environment you typically want your bond holdings to have the lowest duration possible to protect the value of your principal from potentially precipitous declines if interest rates rise quickly.

Of course, this works the other way around, too. If interest rates fell, your bond price would likely go up.

How This Impacts You and Your Portfolio

You should never invest in something you don’t understand — and bonds are no exception. Know what you own in your portfolio, and how to apply this new found knowledge to make smarter investment decisions.

Here are a few other things to keep in mind.

You should also be aware if you’re investing in callable bonds. This means the issuer can retire the bond before it reaches maturity. This is more likely to happen if interest rates begin to climb.

Most bonds come with investor protections that state even if a bond is called, you’ll still receive your payments for a certain number of years. Review the terms of your bond carefully to determine its callable status and protections.

If investing U.S. Government Bonds, Bond Funds, or ETF’s, one common misconception is you have nothing to worry about when interest rates rise, as your principal is guaranteed by the U.S. Treasury, this is not always the case. If you own a U.S. Government bond mutual fund or ETF, your principal can fluctuate just like any other bond fund when interest rates rise (or fall) regardless of the fact you are invested in U.S. Government bonds within the fund or ETF.

Your key take-away should be this: know what you own in your portfolio and make sure your investment strategy takes the appropriate amount of risk for you into account before you decide on the right bond allocation for you.

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This article is for informational purposes only and is not intended to replace the need for independent financial advice. Individuals are encouraged to seek the advice from their financial professional.