Bonds and interest-rate risk

Bonds pay interest, but their prices move opposite to interest rates. Duration estimates how much.

Bond Coupon Yield Duration Interest-rate risk Credit risk

How a bond works

A bond is a loan. The issuer promises regular interest payments (the coupon) and to repay the face value at maturity. A $1,000 bond with a 4% coupon pays $40 a year until it matures, then returns the $1,000 — assuming the issuer doesn't default.

Why prices fall when rates rise

Suppose new bonds start paying 5%. Nobody will pay full price for your older 4% bond, so its market price drops until its yield is competitive. The reverse happens when rates fall. If you hold an individual bond to maturity and the issuer pays, you still get the face value; but a bond fund never 'matures', so its price moves with rates.

Duration: a sensitivity estimate

Duration, in years, is a rule of thumb for rate sensitivity: price change ≈ −duration × change in yield. A fund with duration 6 would fall roughly 6% if yields rose one percentage point. It is an approximation that works best for small moves.

Longer maturities usually mean higher duration and bigger swings. Short-term bonds move less but may pay less.

Other bond risks

Credit risk: the issuer may not pay. Lower-rated bonds usually pay more because of this. Inflation risk: fixed payments buy less if prices rise. Bonds are generally steadier than stocks, not risk-free.

Worked example

A rate rise hits a bond fund (hypothetical)

$10,000 in a bond fund with duration 6 years.
Yields rise by 1 percentage point.
Estimated price change ≈ −6 × 1% = −6% → about −$600, leaving ≈ $9,400.
A short-term fund with duration 2 would move ≈ −2%, or about −$200.

Duration tells you roughly how much a bond holding could fall per 1-point rise in rates. Longer duration, bigger swing.

Common misconceptions

“Bonds can't lose money.”

Bond prices fall when rates rise, and issuers can default. Bond funds can post losing years.

“A higher yield is simply better.”

Higher yield usually comes with more credit risk, longer duration, or both.

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