What is a bond, and why do bond prices fall when rates rise?

When you buy a bond you are lending money. The issuer, a government or a corporation, agrees to pay you a stated interest rate, called the coupon, on a set schedule and to return the principal, called the face value, at maturity. That is the entire structure. Bonds are considered less risky than stocks because you are a creditor rather than an owner, meaning you get paid before shareholders if the issuer runs into trouble, and because the payment schedule is contractual rather than discretionary.

The inverse price relationship confuses people because it seems backward. Imagine holding a bond paying 3 percent when newly issued bonds start paying 5 percent. Nobody will buy yours at full price when they can get a better rate elsewhere, so the market price of your bond falls until its effective yield to a new buyer matches what is available. If rates fall instead, your 3 percent bond becomes attractive and its price rises. This is why a bond fund can lose money in a rising-rate year despite holding nothing that defaulted, which surprised many investors during the sharp rate increases of 2022.

Two properties determine how much this matters to you. Duration measures price sensitivity to rate changes, and longer-maturity bonds swing far more than short-term ones, so a thirty-year Treasury is a much more volatile instrument than a two-year note despite both being government debt. And credit quality determines default risk, which is what ratings agencies attempt to measure, with Treasuries considered the benchmark for safety and high-yield or junk bonds paying more precisely because the risk of not being repaid is real. If you hold an individual bond to maturity and the issuer does not default, interim price swings do not affect what you receive, which is a meaningful distinction from holding a bond fund that never matures.