It has been essentially observed in the market that there is an inverse relationship between bond prices and interest rates. To explain the relationship between bond prices and bond yields, let’s use an example. First, let’s disregard today’s artificially-induced interest rate environment and assume you’ve just purchased a bond with a maturity of five years, a coupon of 5.0%, and you bought it at par (i.e.; 100%), investing $1,000. At this point, your bond is worth exactly what you paid for it, no more and no less. Also, just to be clear, you will receive annual interest of $50 ($1,000 x 5.0% = $50), plus a return of your principal at maturity.
However, the market value of your bond will fluctuate after your purchase as interest rates rise or fall. Let’s assume that interest rates rise. In fact, let’s assume they rise to 7.0%. Because new bonds are now being issued with a 7.0% coupon, your bond, which has a 5.0% coupon, is not worth as much as it was when you bought it. Why? If investors can invest the same $1,000 and purchase a bond that pays a higher interest rate, why would they pay $1,000 for your lower-interest bond? In this case, the value of your bond would be less than $1,000.
Hence, your bond would be trading at a discount. Conversely, if interest rates were to fall after your purchase, the value of your bond would rise because investors cannot buy a new issue bond with a coupon as high as yours. In this case, your bond would be worth more than $1,000. Hence, it would trade at a premium. The bottom line is this.
The market value of a bond will fluctuate as interest rates rise and fall. Now let’s discuss bond funds.
First, invest in short term bonds. Bonds with longer maturities will be hit harder when interest rates rise. Second, consider individual bonds, but be careful with the credit quality of the issuer. You’ll want to be sure the company is financially solid and able to repay your principal when the bond matures.
Even so, I would stick with shorter term bonds. After all, you don’t want to be locked into a low rate for a long time. Third, remember that bonds with higher coupons are better insulated against rising interest rates.