What Happens to Bonds When Interest Rates Go Up?

When interest rates go up, the market price of bonds you already own goes down. New bonds coming to market offer higher coupon payments, so buyers will not pay full face value for an older bond locked into a lower rate. The size of the price drop depends on how long until the bond matures and how high its coupon is, and the loss only becomes real if you sell before maturity. A one-percentage-point rise in rates can push a 10-year bond from $1,000 down to roughly $925, depending on its remaining term and coupon.¹

Why the Price Falls

A bond’s coupon is fixed for life. When you buy a bond paying 3%, it pays that same dollar amount every period until maturity, no matter what rates do afterward. If the Federal Open Market Committee raises its target rate, newly issued bonds start offering higher coupons to match the new environment.² Your 3% bond suddenly looks worse than a fresh 4% bond selling for the same $1,000.

To sell the older bond on the secondary market, you have to discount the price enough to make up for the gap in interest payments. In the SEC’s example, a 3% bond’s price falls to around $925 when market rates reach 4%. At that discounted price, the buyer collects the fixed 3% coupon plus a $75 gain at maturity, which together deliver a total return equal to the 4% they could earn on a new bond.¹ The coupon never changes. All the adjustment happens through the price.

How Much the Price Falls Depends on Duration

Not every bond reacts the same way to a rate change. Duration, measured in years, estimates how much a bond’s price will move for each one-percentage-point change in rates. A higher duration number means a bigger price swing.³

Two things drive duration. The first is time to maturity. A bond with six months left barely moves because you get your principal back almost immediately and can reinvest at the new rate. A 30-year bond locks you into below-market payments for decades, so its price has to fall much further to find a buyer. The second is the coupon rate itself. A high coupon returns more of your money early through interest payments, which shortens the effective duration. A low coupon leaves more of the total value riding on the final principal repayment, which lengthens duration and increases sensitivity to rates.⁴

Zero-coupon bonds show this at the extreme. They pay no interest along the way. You buy them at a discount and collect the full face value at maturity, so every dollar of return sits in that single future payment. Their duration equals their full term to maturity, which makes them the most price-sensitive bonds for any given maturity length.⁵ A 20-year coupon bond might have a duration of 13 or 14 years. A 20-year zero has a duration of 20. The same rate increase will hit the zero much harder.

Is the Loss Real?

If you hold an individual bond until it matures, the price drop on the secondary market never costs you anything. You still receive the full face value on the maturity date, plus every coupon payment along the way. The interim decline is a paper loss. It becomes a real loss only if you sell early.

Selling into a rising-rate market locks in that capital loss. Holding through to maturity avoids the price risk entirely. The trade-off is the opportunity cost: your money stays tied to a below-market coupon for the rest of the bond’s life, when it could have earned more elsewhere.

Bond Funds Behave Differently

Bond mutual funds and bond ETFs do not have a maturity date. The manager continuously buys and sells bonds inside the portfolio, and the fund’s net asset value reflects the current market prices of everything it holds. When rates rise, the fund’s share price falls with its underlying bonds, and nothing guarantees you ever get your original investment back.

So fund investors cannot wait out a rate increase the way individual bondholders can. If you sell shares after rates rise, you realize the loss. Funds offer diversification and professional management that are harder to replicate when buying individual bonds, but the price certainty of a bond you hold to maturity is a feature funds do not have.

The Upside: Reinvestment at Higher Rates

Rising rates do more than one thing to a bond portfolio. The resale value of what you already own drops, but every dollar you reinvest earns more. Coupon payments can go into new bonds at the higher prevailing rate. When a bond matures and your principal comes back, you can buy a replacement with a better coupon than the one that just ended.

Over a long enough holding period, that reinvestment benefit can offset much of the initial price decline. Price risk and reinvestment risk move in opposite directions: the same rate increase that drags your bond’s market price down raises the return on everything you reinvest going forward.

Ways to Reduce Your Exposure

You cannot eliminate interest rate risk, but you can soften it.

Build a Bond Ladder

A ladder spreads your money across bonds that mature at staggered intervals, such as one, three, five, seven, and ten years out. Whenever the shortest rung matures, you reinvest the proceeds in a new long-term bond at the far end of the ladder. If rates have climbed in the meantime, that reinvestment happens at the higher yield. You never have all your capital locked into a single rate environment.

Shorten Your Duration

Shifting toward shorter-maturity bonds reduces the duration of your portfolio and directly limits the price drop when rates rise. A portfolio of two- or three-year bonds will see much smaller declines than one built around 20- or 30-year holdings. The cost is yield: in normal environments, shorter bonds pay less.⁴

Use Floating Rate Notes

Treasury Floating Rate Notes adjust their interest payments to track current rates. The rate on a Treasury FRN is tied to the most recent 13-week Treasury bill auction and resets every week, with a fixed spread set at the original auction added for the life of the note. Because the rate updates so often, FRN prices stay close to par even when the broader market moves, which makes them much less sensitive to rate hikes than fixed-rate bonds.⁶

Consider TIPS for Inflation

Rate increases often come with inflation. Treasury Inflation-Protected Securities adjust their principal up or down based on the Consumer Price Index, and interest payments are calculated on the adjusted principal. At maturity, you receive either the inflation-adjusted principal or the original face value, whichever is greater.⁷ TIPS still carry interest rate risk, since their prices can fall when real yields rise, but they protect purchasing power against the inflation that often drives rate increases.

Taxes on Bond Losses and Discount Purchases

Selling a bond for less than you paid creates a capital loss. Capital losses offset capital gains dollar-for-dollar, and if your losses exceed your gains, you can deduct up to $3,000 per year ($1,500 if married filing separately) against ordinary income. Any unused loss carries forward to future tax years.⁸

If you are on the buying side after rates have risen and you pick up someone else’s bond at a discount, the tax treatment of your eventual gain changes. When you later sell the bond or it reaches maturity, any gain up to the amount of accrued market discount is taxed as ordinary income rather than as a capital gain. Only the portion of your gain above the accrued market discount qualifies for the lower capital gains rate. A small-discount exception treats the discount as zero if it is less than 0.25% of face value multiplied by the number of full years remaining to maturity, in which case the gain is taxed as a capital gain.⁹

1
SEC.gov. Interest Rate Risk – When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall
2
Federal Reserve System. Federal Open Market Committee
3
FINRA.org. Bonds
4
FINRA.org. Brush Up on Bonds: Interest Rate Changes and Duration
5
FINRA.org. The One-Minute Guide to Zero Coupon Bonds
6
TreasuryDirect. Floating Rate Notes (FRNs)
7
TreasuryDirect. Treasury Inflation-Protected Securities (TIPS)
8
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
9
Internal Revenue Service. Publication 550 (2024), Investment Income and Expenses