The Seesaw for Bond Prices and Interest Rates

Lately, the S.E.C. has been giving a warning, the general title being “Interest Rate Risk” This latest bulletin is a cry for understanding. It’s about bonds, and for most people, the subject is confounding.

The problem is a lack of knowledge about how bonds work, which can be dangerous in a time of rising interest rates. In its bulletin, the agency points out that investors need to understand that when rates rise, bond prices generally fall. This inverse relationship is a fact of life in the bond market. Like gravity in the physical world, it’s constant, powerful and important. If interest rates do go higher, most people don’t understand how that will affect bonds.   

As far as bonds go, Ms. Schock from the SEC said, one way to visualize the relationship of interest rates and prices is to think of what she calls “a teeter-totter.” She’s from Indiana. In Delaware, where I come from, we call it a seesaw. Whatever you call it in your playground, imagine interest rates sitting on one side of a plank and bond prices clinging to the other. When one side rises, the other falls.

That’s just the way seesaws work, and it may be enough explanation. But suppose you want to go a little deeper: Why do interest rates and bond prices move like this? 

It’s important right now because interest rates have risen since the spring, and, therefore, prices have fallen. If you don’t understand the relationship between prices and rates (often called yields) you could hurt yourself “by reaching for yield, buying bonds that you think are going to pay you more interest, only to see rates go up further, so the value of your bonds will fall,” Ms. Schock said.

Many people are in danger of getting hurt this way. “We’re concerned that many people might mistakenly think that there’s safety in investing in bonds,” she said, “when there’s actually a fairly good chance of running into trouble with interest rate risk now.”

 Interest rates on Treasuries — and a range of other bonds — have already risen sharply, and a broad consensus of market analysts says they are likely to rise further in the years ahead. Historically, rates are still relatively low, largely in response to the policies of the Federal Reserve.  But it’s better if you understand what’s going on. Remember the seesaw: 

When yields rise, prices fall. 

Macro Minute -- Bond Prices and Interest Rates - YouTube 

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