Why Do Bond Prices Fall When Market Interest Rates Increase?
One question we often get is, why are bond prices falling, yet interest rates are going up? The answer is simple, that’s just how it works. When the FED raises interest rates, bond prices will go down and vice versa. The explanation for this is that a bond is a loan to a company that then pays the interest to you on a monthly or annual basis. Say you put $10,000 into an annual bond. You will get $1,000 a year in interest. In a higher inflation economy, that money is worth less than it is in a low inflation economy.
In a bond portfolio, over time the portfolio itself will reset because as the lower-valued bonds and the principal is paid back, the new bonds coming in are higher yield. This is why you keep investing in new bonds because the income will make up for the losses over time. It all has a lot to do with purchasing power. If interest rates are higher, the cost of living is typically higher as well, and vice versa.
Stocks work similarly except for you are not lending money to a company, you’re investing in a company and buying voting shares. Therefore those prices are going to move up and down based on the perceived value of the company. The downside here is that if you invest in a company that goes out of business, you get nothing – whereas with a bond you have collateral.
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