Bond Prices and Interest Rates

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By Selena Maranjian (TMF Selena)
March 19, 2003

Q. Why do bonds fall in value when interest rates rise?

A. Let's say that yesterday you invested $10,000 in newly issued bonds that mature in 10 years and yield 5%. You'll get $500 per year and then $10,000 at maturity.

But a few years later, interest rates have risen, and investors can buy new 10-year bonds that yield 10%. Your 5% bonds don't look so good anymore, so if you wanted to sell them before they mature, you'd have to ask for much less than the $10,000 you paid. However, if you hold the bonds to maturity, you'll get your $10,000 back, assuming the issuer isn't bankrupt.

This is not necessarily true of bond mutual funds. Since funds do not have maturities, there's no guarantee investors will get their principal back. On the flip side, bond mutual funds offer the potential of capital appreciation. Just as rising interest rates cause bond prices to fall, declining interest rates drive up bond prices -- which is what has happened over the past few years as rates have declined to 40-year lows, much to the delight of bond fund shareholders.

However, many experts are cautioning against investing in bond funds now. Rates can't get too much lower, which means it's more likely that rates will increase over the next few years -- which would cause bond prices to fall.

Learn more about bonds and stocks in our Bond Center, at BondsOnline, or SavingsBonds.gov. Also, check out our Mutual Fund area, and zero in on our index fund information there.

This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource.