Why rising interest rates make the bond market crazy

Traders signal offers in the Ten-Year Treasury Note options pit at the CME Group following the announcement by the Federal Open Market Committee (FOMC) that they would maintain the key policy rate near zero on March 15, 2011 in Chicago, Ill.

OK. Pack fast. We're going back to college.

Dartmouth, specifically. And we've got a Bonds 101 class to get to, taught by economics professor Charlie Wheelan.

Wheelan: All right, let's get started with class. Adriene, is there a reason you were late today?

Hill: Kai had a question about the homework, sorry.

Wheelan: OK, well you're here now. Let's talk about bonds. A bond is essentially a loan where I'm going to give you some money, and you are going to give it back to me at some point in the future. I'm not going to loan you the money out of the goodness of my heart, you're going to pay me a rental rate on the money that I'm give you. That rental rate is going to be some rate of interest.

Hill: So Professor Wheelan, here's what I don't get, why the inverse relationship between interest rates and bond prices? Higher interest rates should be good for bonds, right? They're going to pay more money?

Wheelan: No, because when interest rates go up, the bonds that paid the old lower interest rates are now worth less. So that's the way to think about it. Someone has a newer, shinier bond; what newer, shinier means in the bond market is that it pays a higher interest rate. So you have the old bond that pays 3 percent, the new bond at roughly the same price pays 4 percent, so the only way to unload your less shiny bond is to lower the price of it.

Hill: Got it. And we're talking about this now because we think Fed policy is going to push interest rates up, which could push down bond prices?

Wheelan: Exactly, interest rates have already started going up. So we've seen that movement a little bit, but we expect it might become even more significant.

Hill: Which means lower prices for anyone invested in bonds. It's all getting clear.

Wheelan: Thank you. Have a good Fourth, and I'll see you next week.

About the author

Adriene Hill is the senior multimedia reporter for LearningCurve.

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