How do interest rate developments affect bonds?

Interest rate movements directly affect bonds, but with the right understanding it’s easier to assess the opportunities and risks.

• Rising interest rates generally lead to falling bond prices, while falling interest rates usually result in rising prices.
• Bonds with long maturities and high duration are particularly sensitive to interest rate changes.
• Investors who hold bonds until maturity are usually less affected by interim price fluctuations.
• Diversification and an appropriate maturity profile help manage interest rate risks in a portfolio.

BondsGo to article about bonds., also known as debentures or notes, are among the simpler forms of investment. At the time of purchase, investors know what the interest rate is and when the invested money will be repaid. Investors receive the nominal value back at maturity.

However, the price of a bond can change during its term. The key factor here is the interest rate environment. Price fluctuations are particularly pronounced for bonds with longer maturities, as their interest rate is fixed over a longer period.

The interest rate environment is closely linked to economic developments:

• Rising inflation often leads to higher interest rates.
• When the economy is weak, central banks such as the Swiss National Bank or the European Central Bank often lower key interest rate.

Such monetary policy decisions have a direct impact on the bond markets.

Rising interest rates: falling bond prices

When interest rates rise, existing bonds lose value. New bonds then offer higher coupon rates and become more attractive to investors. Older bonds with lower interest rates then have to trade lower so their yield becomes competitive again.

A simple example: An existing bond with a 1% coupon becomes less attractive when new issues are already offering 2%. This effect is particularly evident with long-term bonds.

Falling interest rates: rising bond prices

Conversely, when interest rates fall, the appeal of existing bonds with higher coupons increases. Demand for these securities increases, which can support or raise their prices. Bonds with longer remaining maturities benefit the most from this.

Special case: variable-rate bonds

Floating rate notes regularly adjust their coupon rate to current market levels. As a result, they are usually less susceptible to price losses when interest rates rise. Conversely, they typically benefit less from price gains when interest rates are falling.

A clear outlook until maturity

For investors, price fluctuations are particularly relevant when a bond is sold before maturity. Those who hold bonds until maturity usually receive the nominal value back. To reduce interest rate risks, it may make sense to invest in bonds with different maturities.

Other influencing factors

Several characteristics of a bond directly affect its duration and thus its interest rate sensitivity:

• Convexity: Convexity describes how the duration itself changes in response to interest rate changes. Bonds with high convexity react less linearly to significant interest rate movements and can partially cushion price losses.
• Coupon amount: Bonds with higher coupon payments generally have a shorter duration, since a larger portion of the cash flows is received earlier.
• Maturity and duration: The maturity indicates when the capital will be repaid. Duration measures the weighted average of cash flows. Two bonds with the same maturity can therefore have different interest rate risks.
• Credit spread: If the risk premium is high, the price often reacts more strongly to changes in the issuer’s creditworthiness than to changes in the general interest rate level.

The interest structure or yield curve shows the yields offered by similar bonds over different remaining maturities. As a graphic representation, it is called the interest structure curve or yield curve. Investors can see from it what returns a bond can earn, depending on the remaining maturity. Government bonds are particularly relevant here. There are four variants of the yield curve:

• Normal (rising) yield curve: Under a normal yield curve, yields increase as maturity increases. The longer investors do without the money they have invested, the better they are compensated.
• Flat yield curve: When the curve is flat, bonds of all remaining maturities offer similar coupon rates. This is usually the case when interest rates are expected to fall.
• Inverted (falling) yield curve: Under an inverted yield curve, yields fall as maturity increases. If high coupon rates are paid on short-term bonds, this tends to indicate an impending recession.
• Irregular yield curve: A combination of the above-mentioned curves, for example rising yields on short-maturity bonds and falling yields on long-maturity bonds.

Interest rate changes cannot be controlled – but the structure of a bond portfolio can.

• Understanding the relationship between interest rates, maturity and duration allows investors to assess risks more effectively.
• An appropriate maturity profile helps balance interest rate sensitivity and reinvestment risks in a portfolio.
• Diversification across issuers, sectors and maturities strengthens the resilience of a bond portfolio.
• Funds and ETFs can facilitate access to a professionally managed bond strategy.

Those who view interest rate cycles not only as a risk but also as a shaping factor can strategically integrate bonds into their long-term financial planning.