When interest rates go up, the market prices of bonds you already own go down. Newly issued bonds start paying higher coupons, so buyers on the secondary market will only pay a discount for your older, lower-paying bond. The Securities and Exchange Commission illustrates the effect with a 10-year bond whose price falls from $1,000 to roughly $925 after a one-percentage-point rate increase.1SEC.gov. Interest Rate Risk – When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall Whether that decline actually costs you anything depends on what kind of bond you own and whether you need to sell it.
Why the Price Falls
A bond’s coupon is fixed at issue. If you bought a $1,000 bond paying 3% and market rates then climb to 4%, no buyer will pay you full face value when they could buy a new bond earning 4% for the same money. To sell, you have to discount the price enough that the buyer’s combined return, from your lower coupon plus the built-in gain when the bond matures at $1,000, matches what a new bond offers. In the SEC’s example that discount lands near $925.1SEC.gov. Interest Rate Risk – When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall
Your coupon payments themselves do not change. A 3% bond keeps paying 3% of face value every period until maturity. The entire adjustment happens through the market price.
How Much a Bond Drops Depends on Duration
Not every bond loses the same amount. Duration, expressed in years, measures how sensitive a bond’s price is to a one-point change in rates. Higher duration means bigger price swings.2FINRA.org. Bonds
Two things drive it. The first is time to maturity. A bond maturing in six months barely moves, because your principal is coming back soon and you can reinvest at the new higher rate. A 30-year bond locks you into below-market payments for decades, so its price has to fall much further to attract a buyer. The second is coupon rate. A high-coupon bond returns more of your money to you sooner, shortening effective duration. A low-coupon bond keeps most of its value tied up in the final principal payment and moves more when rates change.3FINRA.org. Brush Up on Bonds: Interest Rate Changes and Duration
Zero-Coupon Bonds Move the Most
Zero-coupon bonds pay no interest along the way. You buy them at a discount and collect the face value at maturity. Because the entire payoff is a single amount years in the future, their duration equals their full term to maturity, making them the most rate-sensitive bonds available.4FINRA.org. The One-Minute Guide to Zero Coupon Bonds A 20-year coupon-paying bond might have a duration of 13 or 14 years; a 20-year zero has a duration of 20. The same rate increase hits the zero much harder.
Does the Price Drop Actually Cost You Money?
If you hold an individual bond to maturity, no. You receive the full face value back on the maturity date regardless of what happened to the bond’s market price in between, plus every coupon payment along the way. The interim decline is a paper loss. It only becomes real if you sell early.
Selling before maturity during a rate spike locks in a capital loss. Holding to maturity eliminates price risk on that bond entirely. The cost of holding is the opportunity cost: you keep earning your original coupon while newer bonds pay more.
Bond Funds Do Not Mature
Bond mutual funds and bond ETFs work differently. They have no fixed maturity date. A manager continuously buys and sells bonds inside the portfolio, and the fund’s share price, its net asset value, reflects the current market prices of everything it holds. When rates rise, the NAV drops with the underlying bonds, and there is no maturity date on which you are guaranteed to get your original investment back.
That means fund investors cannot wait out a rate increase the way an individual bondholder can. If you sell fund shares after rates rise, you realize the loss. Funds offer diversification and professional management that are hard to replicate with individual bonds, so the choice is a trade-off worth thinking about before rates move, not after.
What You Can Do About Rate Risk
You cannot eliminate interest rate risk from a bond portfolio, but you can shape how much of it you carry.
Build a Bond Ladder
A ladder spreads money across bonds maturing at staggered intervals, for example one, three, five, seven, and ten years out. When the nearest bond matures, you reinvest the proceeds in a new long-term bond at the far end. If rates have climbed, that reinvestment happens at the higher yield. You avoid committing all your capital to a single rate, and you get regular chances to capture better returns.
Consider Floating Rate Notes
Treasury Floating Rate Notes reset their interest payments to track current conditions. The rate is tied to the most recent 13-week Treasury bill auction and resets weekly, with a fixed spread set at the FRN’s original auction. Because the coupon updates as rates move, FRN prices stay close to par, and they are far less sensitive to rate hikes than fixed-rate Treasuries.5TreasuryDirect. Floating Rate Notes (FRNs)
Shorten Duration
Shifting toward shorter maturities directly limits how much value you can lose. A portfolio of two- and three-year bonds will decline far less than one loaded with 20- and 30-year holdings when rates rise. The cost is yield: shorter bonds normally pay less in a stable-rate environment.3FINRA.org. Brush Up on Bonds: Interest Rate Changes and Duration
Add TIPS for Inflation Exposure
Rate increases often follow rising inflation. Treasury Inflation-Protected Securities adjust their principal up or down with the Consumer Price Index, and interest is calculated on the adjusted principal. At maturity you get either the inflation-adjusted principal or the original face value, whichever is higher.6TreasuryDirect. Treasury Inflation-Protected Securities (TIPS) TIPS still carry rate risk, since their prices fall when real yields rise, but they protect the purchasing power that rate hikes are often designed to defend.
Rising Rates Help You on Reinvestment
The same rate increase that hurts the resale value of your existing bonds improves the return on every dollar you put back to work. Coupon payments received during a rising-rate stretch can be reinvested at the higher prevailing yields. When a bond matures, the returned principal buys a new bond with a better coupon than the one that just expired. Over a long enough holding period, this reinvestment benefit can offset a portion, and sometimes all, of the initial price decline. Price risk and reinvestment risk pull in opposite directions.
Tax Points Worth Knowing
If you do sell at a loss, you can use it. Capital losses offset capital gains dollar-for-dollar, and losses beyond your gains can offset up to $3,000 of ordinary income per year ($1,500 if married filing separately). Unused losses carry forward to later years.7Internal Revenue Service. Topic No. 409, Capital Gains and Losses
If you are the buyer picking up a discounted bond on the secondary market, watch the market discount rule. When you later sell or the bond matures, gain up to the amount of accrued market discount is taxed as ordinary income rather than as a capital gain. Only gain above that accrued discount qualifies for capital gains rates. A small-discount exception applies when the total discount is less than 0.25% of face value multiplied by the full years remaining to maturity; below that threshold, the discount is treated as zero and the gain is a capital gain.8Internal Revenue Service. Publication 550 (2024), Investment Income and Expenses
One more tax angle matters after rate moves push people toward Treasuries. Interest on U.S. Treasury bonds, notes, and bills is exempt from state and local income taxes under federal law, though not from estate or inheritance taxes.9Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation In a state with income tax, that can make Treasury yields more competitive than corporate yields on an after-tax basis, even when the stated coupon is lower.