What Happens to Bond Prices If Interest Rates Rise?

Bond yields have whipsawed in 2021. With the Fed's meeting coming up later in September, many investors want to know how interest rates will react to the Fed's policy decision. Also, what happens to bond prices if interest rates rise?

U.S. interest rates have been in a secular decline over the last three decades. There have been some aberrations in between and rates have increased momentarily. For example, bond yields went up due to fears of high inflation in the first quarter of 2021. While many people expected U.S. 10-year yields to rise to 2 percent, rates have instead come down from the 2021 highs.

Bond prices and yields are inversely related. This means that bond prices fall if the interest rates rise. Conversely, if the interest rates fall, bond prices go up. Bond markets have been in a bull market since the 1980s. Falling bond yields have led to higher returns for bond investors.

Meanwhile, it's worth noting that the changes in interest rates impact bond prices differently. Simply put, bonds with longer maturity are more sensitive to the changes in interest rates. So, if interest rates rise, bonds with a higher maturity would fall more than a bond with a lower maturity. The phenomenon of bond prices reacting to interest rates is known as "interest rate risk."

Bonds that have a lower coupon are more sensitive to interest rates. So, if interest rates rise, bonds with a lower coupon would fall more. Here we are assuming that all other aspects of the bonds, including the maturity and credit quality, are similar.

Another aspect to note would be that the price of floating-rate bonds is less sensitive to the changes in interest rates. The relationship isn't hard to understand. The coupon on a floating rate bond would adjust to the changes in interest rates. However, since the coupon on a fixed rate bond is fixed, the yields react to the prevailing interest rate environment.

As a rule of thumb, if you expect bond yields to rise, it's always prudent to position your portfolio in either floating rate bonds or in bonds that have a lower maturity. Conversely, if you expect rates to fall, you can invest in bonds with a higher maturity profile and lock in the higher rates.

In March 2020, the Fed lowered the benchmark interest rates to zero bound and embarked on a historical bond-buying program. The accommodative monetary policy, which was complemented with easy fiscal policy, helped bring stability in the U.S. economy as well as the financial markets.

Now, with inflation running near multi-year highs and the U.S. economy bouncing back sharply from the 2020 lows, the Fed is expected to unwind some of the aggressive steps that it took in 2020. While no one expects it to raise rates, tapering, or scaling back on $120 billion monthly bond purchases, could be in the cards.

The U.S. central bank is meeting later in September and tapering might be discussed at the event. It's largely believed that the Fed could start tapering sometime in 2021 and begin the process of reversion towards a more normalized monetary policy.

However, bond yields don't necessarily rise when the Fed announces a rate hike or monetary policy tightening. The yields are more a function of what the market thinks the Fed’s policy and future interest rates will be.