When interest rates rise, bond prices fall. As we saw previously regarding bonds held by banks, this is one of the representative effects brought about by rising interest rates. Bonds issued at low interest rates look inferior compared to newly issued bonds with higher interest rates, so their market price drops.
However, in recent financial markets, expressions that seem to contradict this have begun to be heard. Phrases such as ‘the appeal of bonds has returned’ and ‘the era of bonds has returned’ are being used. Since they are products whose prices fall due to rising interest rates, why does their appeal as an investment destination increase?
The key to solving this question lies in considering those who already own bonds and those who are about to buy bonds separately. When interest rates rise, already issued low-interest bonds fall in price. On the other hand, the interest rates on newly issued bonds become higher, and the fallen existing bonds can also be bought at a higher yield than before.
In other words, even with the same interest rate hike, the view is different for those who held bonds before the rate hike and those who are trying to buy bonds after the rate hike. The fact that bond prices fall due to rising interest rates and the fact that the appeal of bond investment increases are not contradictory.
During the long era of zero interest rates, even if one held highly safe bonds, a state where almost no interest could be received continued. With the return of a world with interest rates, the option of ‘being able to receive interest without taking large risks’ is also gradually returning. What does the ‘revival’ of bonds mean? First, let’s look at the financial product of bonds themselves.
1. What are bonds in the first place?
Bonds are securities issued by governments, companies, etc., to borrow money. From an investor’s perspective, buying a bond is similar to lending money to the issuing government or company. In return, they receive interest, and when a predetermined time arrives, the principal is repaid.
For example, let’s assume the government issues a government bond with a face value of 1 million yen, an annual rate of 1%, and a 10-year maturity. An investor who bought this government bond for 1 million yen receives 10,000 yen in interest every year, and in principle, receives the 1 million yen principal after 10 years. The 1 million yen here is the ‘face value,’ the interest paid annually is the ‘coupon,’ and the time when the principal is repaid is the ‘maturity’.
Looking only at this mechanism, bonds appear to be quite simple financial products. If you buy a government bond and hold it until maturity, you just need to wait for repayment while receiving the determined interest.
However, there is a market where bonds can be bought and sold midway. This makes the story a bit complicated. The price of bonds traded in the market is not fixed at the 1 million yen from when they were first issued. Depending on the movement of interest rates, it becomes higher or lower than 1 million yen.
Why does the price of a bond, which will return 1 million yen when it matures, move midway? To understand the reason, it is easy to understand by comparing bonds that have already been issued with bonds that will be newly issued from now on.
2. Why do bond prices fall when interest rates rise?
Let’s think using the government bond from earlier. Suppose there is already a Bond A in the market with a face value of 1 million yen that allows you to receive 10,000 yen in interest every year. When this bond was issued, market interest rates were also low, and an annual interest of 10,000 yen was not particularly unnatural.
After that, interest rates rose. Let’s assume that a newly issued Bond B allows you to receive 30,000 yen in interest every year even with the same face value of 1 million yen. Then, for someone investing 1 million yen, Bond B, which allows them to receive 30,000 yen every year, looks more attractive than Bond A, which only allows them to receive 10,000 yen every year.
So, what happens if someone holding Bond A tries to sell it midway? Even if they try to sell it for 1 million yen, the buyer has the option of buying Bond B for 1 million yen. Therefore, it becomes difficult for Bond A to find a buyer unless the price is lowered. This is because even if the interest received every year remains 10,000 yen, if the purchase price becomes cheaper, the profitability for the new buyer increases.
In this way, when market interest rates rise, the price of bonds already issued at low interest rates falls. Conversely, if market interest rates fall, the appeal of bonds that can receive the previous high interest rates increases, and their prices tend to rise. This is the reason why it is said that ‘interest rates and bond prices move in opposite directions’.
What is important here is the point that the promise of Bond A itself has not changed. The condition of paying 10,000 yen in interest every year and returning the face value when it matures remains the same. What has changed is the market interest rate surrounding that bond and its relative appeal when compared to newly appeared bonds.
And, when looking at this price decline from another angle, the next story becomes visible. For those who already own bonds, it is a price drop, but for those who are about to buy them, it also means that they have become able to buy the same bond at a cheaper price than before.
3. Falling prices and rising yields are the same phenomenon
Here, let’s think about bond ‘price’ and ‘yield’ separately. The condition that the aforementioned Bond A allows you to receive 10,000 yen in interest every year does not change. Even so, if the market price falls from 1 million yen to 900,000 yen, those who buy it from now on can receive the same 10,000 yen of interest with a smaller investment amount.
Simply put, if you pay 900,000 yen to receive 10,000 yen every year, the return on the amount paid is greater than if you pay 1 million yen to receive 10,000 yen every year. Actual bond yields are calculated not only by annual interest but also by including the purchase price, the time until maturity, and the fact that the face value is redeemed at maturity. Even so, the fundamental relationship that ‘if prices fall, the yield obtained by those buying from now on increases’ remains unchanged.
Here, the perspective on rising interest rates changes the view. For someone who held government bond A before the interest rate hike, it is a decline in market price. If they sell it midway, they might sell it at a lower price than when they bought it. On the other hand, for someone who is about to buy government bond A, it is an opportunity to obtain a higher yield because they can buy it cheaper than before.
In other words, the news that ‘bond prices have fallen’ and the news that ‘bond yields have risen’ do not necessarily convey separate events. It is a difference in whether you view the same market adjustment from the price side or the yield side. And even for the same change, the meaning differs between those who already own bonds and those who are about to buy them.
Once you understand this difference, you can see why it is said that ‘the appeal of bonds has returned’ after bond prices fell due to rising interest rates. The issue is not just whether bond prices have risen or fallen. It is about what level of yield people who are investing funds from now on have become able to obtain.
4. So, why is it a ‘bond revival’ now?
If it were just the story so far, it would be a market mechanism where bond prices fall due to rising interest rates, and as a result, yields rise. Then why has the term ‘bond revival’ started to be used recently? Its meaning is easier to understand when compared to the long-lasting era of zero interest rates.
In the era of zero interest rates, even if you bought highly safe government bonds, the interest you could receive was negligible. If you keep 1 million yen in bonds and it generates almost no return, there is no big difference from keeping it as cash or deposits. On the other hand, investors seeking slightly higher returns needed to direct their funds toward stocks, corporate bonds, foreign bonds, real estate, etc.
When interest rates return, the order of these options changes. For example, if you can obtain a certain yield from highly safe bonds, when investing 1 million yen, it will no longer be a state close to a binary choice of ‘whether to put it in a deposit with almost no interest or buy stocks with large price fluctuations.’ In between, the option of ‘receiving interest while holding relatively safe bonds’ returns.
The meaning of holding bonds also changes. In the era of zero interest rates, government bonds had a strong character as assets that prioritize the safety of the principal. When interest rates rise, the role of interest income is added to that. If you assume that you will hold them until maturity, the way of using them to receive interest that is easy to foresee in advance for a certain period becomes realistic again.
This change also affects how people look at stocks. When you can hardly get any return from highly safe bonds, the reason to hold stocks even while bearing the risk of price fluctuations becomes stronger. However, if you can obtain a certain yield from bonds, a comparison arises: ‘Can I still expect enough return to hold stocks?’ For investors, bonds have become a financial asset that competes with stocks again.
The meaning is also significant for institutional investors. Pension funds and life insurance companies, etc., are managing funds over a long period in preparation for future payments. If the environment becomes one where you can obtain a certain interest from highly safe bonds, it becomes easier to secure investment returns by incorporating bonds without having to force yourself to expand risks in search of high returns.
Therefore, ‘bond revival’ does not simply mean that bond prices have risen. It is a change in which bonds have regained their presence as relatively safe assets that generate interest between deposits and stocks. The original role of bonds, which had faded due to zero interest rates, has returned in a world with interest rates.
However, bonds do not become unconditionally advantageous just because yields become higher. Even bonds bought now may fall in price if interest rates rise further afterward, and the risks borne differ depending on the type of bond. Next, let’s organize those points.
5. Even so, higher interest rates are not necessarily better
If bond yields become higher, the returns that investors who buy from now on can receive will increase. However, if interest rates rise further, the price of the bonds bought now may also fall. This is because today’s ‘high yield’ will be compared to an even higher yield tomorrow.
For example, suppose you bought a bond that pays 3% annual interest, and then market interest rates rose to 4% or 5%. Since newly issued bonds pay higher interest, if you try to sell a 3% annual bond midway, its price is likely to fall. While bonds after an interest rate hike have the appeal of a higher yield than before, the risk that the price will move due to subsequent interest rate fluctuations remains.
Then, is it okay not to worry about price declines if you hold them until maturity? If the issuer pays interest as scheduled and repays the principal at maturity, even if the market price falls midway, it does not mean that the loss is confirmed at that point. For investors who intend to hold until maturity, it is necessary to think about price fluctuations midway and the interest/principal actually received separately.
Even so, it does not mean that the market price becomes completely irrelevant. If you need to sell midway due to unexpected expenses, etc., you may have to sell at a lower price. Also, if market interest rates rise while you are holding low-interest bonds for a long time, you will also miss the opportunity to have ‘invested at a higher yield’.
This impact also differs depending on the length of time until the bond’s maturity. Generally, the longer the period until maturity, the more easily the price moves due to changes in interest rates. While long-term bonds have the aspect of being able to fix the current interest rate for a long period, the price fluctuation when market interest rates change afterward is also likely to be large. One way of thinking to measure the ease of movement of bond prices in response to such interest rate changes is ‘duration’.
Furthermore, not all bonds have the same safety. In the case of corporate bonds issued by companies, higher yields than government bonds may be presented, but in the background, there is also credit risk that the company will be unable to pay interest or repay the principal. You cannot judge the appeal of a bond just by looking at the number that the yield is high.
The return of yields to bonds means that investors’ options have expanded. At the same time, it is necessary to look at what kind of interest rate risk and credit risk those yields are tied to. The news that ‘bonds have revived’ does not mean that bonds have once again become an asset that can be bought without any thought.
6. Read bond news based on ‘where you stand’
In bond market news, expressions such as ‘government bond prices have fallen,’ ‘long-term interest rates have risen,’ and ‘the investment appeal of bonds has increased’ may appear at the same time. At first glance, it looks like bad news and good news for bonds are mixed together. However, what is important for individual investors is not to lump it all together as ‘good or bad for bonds,’ but to think about where they stand.
For those who already hold fixed-rate bonds, rising interest rates work to lower the market price of the bonds they hold. If you plan to sell in the near future, the price decline becomes an important issue. On the other hand, if you intend to hold until maturity and receive the scheduled interest and principal, changes in the market price along the way have a different meaning. Even with the same news of ‘government bond price decline,’ the perception differs between someone selling next month and someone holding until maturity.
For those who are about to buy bonds, the same interest rate rise shows a different face. This is because the interest rates on newly issued bonds become higher, and existing bonds can also be bought at higher yields due to price declines. Government bonds, which were hardly considered as an investment destination during the zero-interest rate era, now enter the comparison as ‘if the yield is this much, I can put some of my funds there.’ This is the concrete form of the ‘revival of bonds’ as seen from the perspective of individual investors.
However, the next judgment arises here. It is the question of whether to lock in the current interest rate for a long time, or to choose bonds with short maturities and reinvest at the interest rate at that time in a few years. If you think interest rates will rise further in the future, locking in for a long period may result in opportunity costs. Conversely, for those who consider the current interest rate sufficiently attractive, there is meaning in being able to secure that yield for a certain period.
Whether the money has a fixed usage time is also important. If it is funds prepared for expenditures in a few years, you can look at how to match that time with the maturity of the bonds. If it is money that is likely to be used along the way, you also need to consider the risk of having to sell when the market price has fallen. Even with the same bond product, its role changes depending on which funds in the household budget are placed in it.
Furthermore, with news that ‘yields have become higher,’ it is also necessary to look at the reason for that height. It means something different if it is high because it is a long-term bond versus if it is high because it is a corporate bond that carries corporate credit risk. If you only compare the yield figures that appear on the surface, it is easy to overlook the risks being taken behind them.
Thinking about it this way, the questions individual investors ask when reading bond news become quite concrete. It is not just ‘will bonds go up or down?’ Do you already own them, or are you about to buy them? How long can the money be invested? For how long do you want to lock in the current interest rate? When linked to these conditions on your side, the meaning of the same interest rate news becomes easier to see.
And once you can earn a certain yield from bonds again, your perspective on stocks also changes. If you can earn returns from highly safe bonds, what level of return can you expect if you still hold stocks with large price fluctuations? In a world with interest rates, the revival of bonds will also affect the valuation of stocks.
Conclusion
When interest rates rise, bond prices fall. This is the basic relationship in the bond market. However, if you look only at this and think ‘rising interest rates are bad for bonds,’ you only see half of the changes currently taking place.
For those who held bonds with low interest rates before the interest rate rise, the rise means a decline in the price of their holdings. On the other hand, for those who are about to buy bonds, the interest rates on newly issued bonds become higher, and existing bonds can also be bought at higher yields than before. The same interest rate rise appears as a price decline for existing holders and as a higher yield for new purchasers.
Therefore, ‘bond prices falling due to rising interest rates’ and ‘the appeal of bond investment increasing’ are not contradictory. Rather, price decline and yield increase are two sides of the same market adjustment.
And the meaning of the ‘revival of bonds’ is not that bond prices themselves have revived. It is that the option of ‘earning interest from highly safe assets,’ which had been almost lost in the era of zero interest rates, has returned. In a world with interest rates, bonds have once again become financial assets worth comparing as a place to park funds.
Then, what looks different next is stocks. When you can earn a certain yield from highly safe bonds, what level of return must you be able to expect to still hold stocks with large price fluctuations? Next time, we will think about ‘do stock prices fall when interest rates rise?’
Reference Materials
・Ministry of Finance ‘Government Bonds for Individuals Product Overview’
Ministry of Finance ‘Government Bonds for Individuals Product Overview’
・Ministry of Finance ‘Government Bonds for Individuals and New Over-the-Counter Bonds Currently Being Offered’
Ministry of Finance ‘Government Bonds for Individuals and New Over-the-Counter Bonds Currently Being Offered’
・Japan Securities Dealers Association ‘Regarding Trading of Public and Corporate Bonds’
Japan Securities Dealers Association ‘Regarding Trading of Public and Corporate Bonds’
・Japan Securities Dealers Association, “Features and Risks of Corporate Bonds for Individuals, and How to Obtain Price Information”
Japan Securities Dealers Association, “Features and Risks of Corporate Bonds for Individuals, and How to Obtain Price Information”
・Japan Securities Dealers Association, “Features and Risks of Financial Products and Transactions”
Japan Securities Dealers Association, “Features and Risks of Financial Products and Transactions”