When you buy a bond, either directly or through a mutual fund, you're lending money to the bond's issuer, who promises to pay you back the principal (or par value) when the loan is due (on the bond's maturity date). In the meantime, the issuer also promises to pay you periodic interest payments to compensate you for the use of your money. The rate at which the issuer pays you—the bond's stated interest rate or coupon rate—is generally fixed at issuance.
An inverse relationship
When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is: How does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of opportunity cost.
Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's coupon rate—which, remember, is fixed—becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. Let's look at an example.
Suppose the ABC Company offers a new issue of bonds carrying a 7% coupon. This means it would pay you $70 a year in interest. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value: $1,000.1
Interest rates and bond prices have an inverse relationship
What if rates go up?
Now let's suppose that later that year, interest rates in general go up. If new bonds that cost $1,000 are paying an 8% coupon—or $80 a year in interest—buyers will be reluctant to pay the $1,000 face value for your 7% ABC Company bond. In order to sell, you'd have to offer your bond at a lower price—a discount—that would enable it to generate approximately 8% to the new owner. In this case, that would mean a price of about $875.1
What if rates fall?
Similarly, if rates dropped to below your original coupon rate of 7%, your bond would be worth more than $1,000. It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market.1
Of course, many other factors go into determining the attractiveness of a particular bond: the length of time until the bond matures, whether or not its interest is taxable, the creditworthiness of its issuer, the likelihood that the issuer will pay off debt early, and more. But the important thing to remember is that change occurs in market interest rates virtually every day. The movement of bond prices and bond yields is simply a reaction to that change.
1. This hypothetical illustration assumes a 7% coupon, $1,000 face value, and a 10-year maturity. The illustration is approximate and is not intended to represent the return of any particular bond or bond fund.
Bond values fluctuate in response to the financial condition of individual issuers, changes in interest rates, and general market and economic conditions.
Mutual fund investing involves risks, including the possible loss of principal, and may not be appropriate for all investors. Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds held by the fund. In general, when interest rates rise, bond values fall and investors may lose principal value. Interest rate changes and their impact on the fund and its share price can be sudden and unpredictable. Funds that concentrate their investments in a single industry may face increased risk of price fluctuation over more diversified funds due to adverse developments within that industry. Foreign investments are especially volatile and can rise or fall dramatically due to differences in the political and economic conditions of the host country. These risks are generally intensified in emerging markets. Smaller- and mid-cap stocks tend to be more volatile and less liquid than those of larger companies. High-yield securities have a greater risk of default and tend to be more volatile than higher-rated debt securities. Consult a fund's prospectus for additional information on these and other risks.