Understanding Bond Interest Rate Risk
Bond prices and interest rates move in opposite directions. When rates rise, existing bonds become less valuable because new bonds pay more. This inverse relationship is captured by duration — the higher the duration, the more sensitive the bond is to rate changes.
Bond price = Σ[Coupon / (1+y)^t] + [Face Value / (1+y)^n]. Modified duration = Macaulay duration / (1 + y), and approximates the percentage price change for a 1% yield shift. Longer maturity and lower coupon bonds have higher duration and greater rate sensitivity.
To reduce interest rate risk in a portfolio, mix shorter-duration bonds or floating-rate instruments. In a rising rate environment, keeping duration low (under 3 years) limits price losses.
Frequently Asked Questions
Enter a negative number for the rate change. For a 25 basis point drop, enter -0.25. The calculator will show a positive price change, reflecting that bond prices rise when rates fall.
If a bond has a modified duration of 5, a 1% rise in rates will cause the bond price to drop by approximately 5%. A 0.5% rise would drop prices about 2.5%.