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Which Interest Rates Affect Bond Prices?

A reader writes in, asking:

“I understand that a bond’s price goes up when interest rates go down and vice versa. Do interest rates usually move together with all rates going up by roughly the same amount? And if not, which interest rate is it that determines bond prices? Federal funds rate? Treasury bond rates? Other??”

Firstly, interest rates do not move in lockstep. For example, if the yield on 1-year Treasuries goes up by 1%, you shouldn’t expect the yield on 10-year Treasuries to necessarily go up by the same amount. It might go up by more than 1%, it might go up by less than 1%, or it might not go up at all.

You can see this by looking at how yield curves change over time. For those who haven’t encountered yield curves before, they are charts that show the yields for bonds of various maturities. For example, the following chart shows the yield curve for Treasury bonds as of the beginning of this year.

YieldCurve

If interest rates rose and fell in lockstep, the yield curve for Treasury bonds would always have this exact same shape — it would simply shift up and down as rates move. But that’s not the case.

The following chart shows the Treasury yield curve as of the first day of business on each of the last 5 years. As you can see, the lines do not share exactly the same shape, because interest rates did not move in lockstep. As it turns out, over those five years, short-term rates moved around much less than longer-term rates.

YieldCurves

And the above chart only looks at Treasury yields. If we were to include yield curves for muni bonds or corporate bonds, we’d see even more diversity.

So Which Rates Affect Your Bonds’ Prices?

Imagine that you’re trying to sell your car. The price you’re going to be able to get for it will depend on what other sellers are charging for cars with the same characteristics (make, model, year, mileage, condition, etc.).

The same thing goes for bonds. If you want to sell a bond, it is the yield on other similar bonds that will determine the price that you’re able to get.

So, for example, if you own a Treasury bond with 5 years remaining until maturity, and interest rates on 5-year Treasuries rise, the market value of your bond will go down. (That is, in order to make your bond as attractive to a buyer as a new, higher-yielding 5-year Treasury would be, you would have to lower the price of your bond until it provides the same yield to the buyer as a new 5-year Treasury would.)

Or, if you hold a portfolio of highly-rated short-term muni bonds, the market value of your bonds will depend on what happens with interest rates for other highly-rated short-term muni bonds.

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