Bond prices and interest rates move in opposite directions. Understanding why — and what the mechanics mean for existing bond holders — is fundamental to fixed-income investing.
A bond is essentially a loan. The buyer of a bond lends money to an issuer — a government or a company — and receives regular interest payments at a fixed rate, called the coupon, until the bond matures and the original amount is returned.
What makes bonds interesting from an investment mechanics standpoint is that the bonds already in circulation trade at prices that fluctuate continuously. Those price movements are driven by changes in interest rates elsewhere in the economy.
The inverse relationship
When interest rates rise, existing bonds become less attractive. This is because a new bond issued at the higher rate would pay more interest than an older bond paying the original coupon. Investors willing to sell an older bond must offer it at a lower price to compensate a buyer for accepting a below-market interest rate. Conversely, when interest rates fall, existing bonds paying a higher coupon become more valuable, and their prices rise.
This is the core inverse relationship: bond prices go up when interest rates go down, and down when interest rates go up.
The magnitude of the price change depends on how far the bond is from its maturity date. A bond that matures in two years will experience far less price volatility from a rate change than one that matures in twenty years. This measure is called duration — a longer-dated bond has higher duration, meaning greater sensitivity to rate moves.
A worked example
Consider a 10-year government bond issued at a coupon of 2 percent, with a face value of $1,000. The investor receives $20 per year for ten years, then $1,000 back at maturity.
Two years after issuance, interest rates in the broader economy have risen to 3 percent. A new 8-year bond from the same issuer now pays 3 percent.
The original 2 percent bond is less attractive. What price would make it competitive? The bond has eight years remaining and will pay $20 annually plus $1,000 at maturity. The combined value of those remaining cash flows, discounted at the new market rate of 3 percent, determines the trading price.
Using standard bond pricing mathematics, the present value of the remaining coupon payments ($20 per year for eight years) and the repayment ($1,000 in eight years) at a 3 percent discount rate comes to roughly $929. This means the bond price has fallen from $1,000 to around $929 — a loss of about 7 percent — simply from a 1 percentage point rise in market interest rates.
If instead rates had fallen to 1.5 percent over the same two-year period, the original 2 percent bond would trade at a premium — approximately $1,034.
Why this matters for fixed-income portfolios
The RBNZ sets the Official Cash Rate, which influences the broader interest rate environment. When the RBNZ raises the OCR, market interest rates tend to rise, which puts downward pressure on existing bond prices. When it cuts the OCR, rates fall, which supports bond prices.
This is one reason why bond investors pay close attention to central bank policy signals. A rate hike cycle announced today will immediately affect the market value of bonds already held, even though the coupon rate on those bonds remains unchanged.
For New Zealand investors, the NZX hosts a market for government and corporate bonds, with regular reporting on rate movements and market activity. Tracking the direction of wholesale interest rates — which banks use to price new lending — gives a forward signal for bond portfolio values. The RBNZ's OCR decisions directly influence these wholesale rates, as RNZ has previously reported when the OCR was lifted to 2.5 percent.
The horizon principle
For investors who hold bonds to maturity, mark-to-market price movements are less directly relevant — they receive the face value when the bond matures regardless of intermediate price fluctuations. The practical impact of rate changes is most significant for those who may need to sell bonds before maturity, or who manage portfolios that must report current market values.
Understanding the mechanics helps frame why diversified portfolios typically include bonds alongside equities — they provide income and typically act differently from shares during various economic conditions, even though they carry their own interest rate sensitivity.
This article is for general information only and is not personalised financial advice. Seek advice from a licensed financial adviser (registered on the FSPR) for guidance specific to your situation.