Why Do Bond Yields Go Down When Interest Rates Go Down?

This is one of the most fundamental relationships in finance, and understanding it is essential for any investor. When we say “bond yields go down when interest rates go down,” we’re describing the same inverse relationship we’ve been discussing - just looking at it from a different angle. Let me explain exactly why this happens and what it means for bond investors.

The Direct Relationship Between Market Rates and Bond Yields

First, let’s clarify an important point: when economists and financial analysts talk about “interest rates” going down, they’re usually referring to market interest rates - the rates at which new bonds are issued and at which existing bonds trade.

When market interest rates decline, several things happen simultaneously:

1. New bonds are issued at lower rates: When the Federal Reserve or other central banks lower their target interest rates, new bonds come to market with lower coupon rates. A 10-year Treasury that might have yielded 5% last month might now yield only 4%.

2. Existing bonds become more valuable: If you already own a bond paying 5%, and new bonds are only paying 4%, your 5% bond is now more attractive to buyers. You can sell it at a premium (above face value).

3. Yields adjust to match prices: Here’s the key point - the “yield” of a bond isn’t fixed like its coupon rate. The yield is calculated based on the bond’s current market price. As the bond’s price rises (because it’s now more valuable when rates fall), its yield falls.

The Mathematical Relationship

Let’s look at this mathematically. The yield of a bond is calculated as:

Yield = Annual Coupon Payment / Current Market Price

This is called the current yield. (There’s also “yield to maturity,” which is more complex, but it follows the same principle.)

Suppose you have a bond with:

• Face value: $1,000
• Coupon rate: 5%
• Annual coupon payment: $50

Scenario A: Market rates are 5%

• The bond trades at par ($1,000)
• Yield = $50 /$1,000 = 5%

Scenario B: Market rates fall to 4%

• New bonds are issued at 4%
• Your 5% bond is now more valuable
• It trades at a premium, say $1,050 (I’ll explain why this specific price shortly)
• Yield = $50 /$1,050 = 4.76%

Notice how the yield dropped from 5% to 4.76% even though the coupon payment remained $50. The only thing that changed was the price.

Why Does This Make Sense?

This relationship makes perfect sense when you think about it from an investor’s perspective. Imagine you’re considering buying a bond. You have two options:

Option 1: Buy a new bond paying 4% coupon Option 2: Buy an existing bond paying 5% coupon, but at a premium price

If the 5% bond trades at exactly $1,000 (yielding 5%), everyone would buy it instead of the new 4% bond. There’s no way the issuer could sell a new 4% bond when a 5% bond is available at the same price.

For both bonds to coexist in the market, the 5% bond must trade at a price that makes its yield approximately equal to the 4% bond’s yield. This is why the 5% bond trades at a premium - the premium price reduces its yield to match current market rates.

The Yield to Maturity Perspective

While current yield is simple, most bond investors look at yield to maturity (YTM), which is more comprehensive. YTM considers not just the coupon payments but also the difference between the purchase price and face value.

For example, if you buy a 5% coupon bond at $1,050 and hold it to maturity (assuming 10 years left and$1,000 face value), you’ll:

• Receive $50 per year for 10 years
• Receive $1,000 at maturity (but you paid$1,050, so you lose $50)

The YTM calculation accounts for both these cash flows and gives you an annualized return that accounts for the capital loss.

When market interest rates fall, the YTM of existing bonds falls because:

1. The bond trades at a higher price (the premium increases)
2. The capital loss at maturity becomes larger
3. Both factors reduce the overall return

The Mechanism of Central Bank Policy

Central banks influence interest rates through monetary policy, and their actions have direct effects on bond yields:

When Central Banks Cut Rates

1. Open market operations: The central bank buys government bonds, increasing demand and pushing prices up and yields down.
2. Policy rate cuts: The central bank lowers its target for short-term rates, which lowers short-term bond yields.
3. Expectations: Markets anticipate lower future rates, which pushes long-term yields down as well.

Historical Examples

Let’s look at some historical periods of declining interest rates:

1980s: After Paul Volcker tamed inflation with high rates, the Federal Reserve gradually lowered rates throughout the decade. Bond prices rose substantially, and bond yields fell. This was a great time to be a bond investor.

2008 Financial Crisis: After the crisis erupted, the Fed cut rates to near zero and launched quantitative easing (buying bonds). Bond yields plummeted, and bond prices soared. Long-term Treasury prices more than doubled from their lows.

COVID-19 Pandemic: In March 2020, the Fed cut rates to near zero again and restarted quantitative easing. Bond yields fell to historic lows, and bond prices rose to historic highs.

2024: As inflation moderated, the Fed began cutting rates, causing bond yields to fall and bond prices to rise.

Why Does This Matter for Investors?

Understanding this relationship has several practical implications:

For Bondholders

If you already own bonds when interest rates fall:

• Your bond prices will rise
• You can sell your bonds for a capital gain if you want
• If you hold to maturity, you won’t realize the capital gain, but you’ll have enjoyed higher yields during your holding period

For New Investors

If you’re buying bonds after rates have fallen:

• You’ll receive lower coupon payments than if you’d bought earlier
• But you might benefit from price appreciation if rates continue to fall
• The total return (coupon + price change) depends on how much rates continue to fall

For Portfolio Construction

This relationship affects how investors build fixed-income portfolios:

Duration strategy: Some investors try to time interest rate changes by adjusting their portfolio duration. If they expect rates to fall, they might buy longer-duration bonds (which have more price appreciation potential).

Laddering strategy: Other investors use bond ladders - portfolios with bonds maturing at different times. This reduces interest rate risk while still providing income.

The Counterintuitive Aspect

This relationship can feel counterintuitive to new investors. They might think: “Rates are going down, so I should earn less on my bonds.” While the coupon rate is fixed, the actual return depends on when you bought and sold.

Consider this example:

• You buy a 10-year bond at 5% yield when rates are 5%
• Rates fall to 3% over the next year
• Your bond now yields 3% (because its price rose)
• If you sell, you get a capital gain
• Your total return = 5% coupon + capital gain ≈ 20%+ in the first year

This is why bond investors can make money even when interest rates are falling - the price appreciation compensates for the lower yields.

The Role of Duration

Duration measures how sensitive a bond’s price is to interest rate changes. The longer the duration, the more the price will change when rates change.

A 30-year bond with a duration of 20 years will see its price change by approximately 20% for every 1% change in interest rates. A 2-year bond with a duration of 2 years will see its price change by only 2% for every 1% change in rates.

This is why longer-term bonds tend to fall more when rates rise and rise more when rates fall. They have more “duration risk” but also more “duration reward.”

Yield to Maturity vs. Current Yield

Let’s clarify the difference between these two yield measures:

Current Yield:

Current Yield = Annual Coupon Payment / Current Price

This measures the income you receive relative to what you paid, but it doesn’t account for capital gains or losses at maturity.

Yield to Maturity (YTM): YTM is more complex. It considers:

• All coupon payments you’ll receive
• The difference between purchase price and face value
• The time value of money

YTM tells you what your total return would be if you held the bond to maturity and reinvested all coupons at the same rate.

When market interest rates change, both current yield and YTM change. YTM is generally more useful for comparing bonds with different maturities and coupon rates.

The Expectations Hypothesis

Financial theory suggests that long-term interest rates reflect expectations of future short-term rates. If investors expect rates to fall in the future, long-term rates will be lower than current short-term rates (which can contribute to yield curve inversion).

This is important for understanding why yields fall when interest rates fall:

• If markets expect rates to fall further, long-term yields will fall
• If markets expect rates to stabilize, long-term yields might not fall as much
• The entire yield curve shifts down when market rates fall

Practical Examples from Recent History

Let’s look at how this played out in recent decades:

The Great Recession (2007-2009):

• The Fed cut rates from 5.25% to near zero
• 10-year Treasury yield fell from about 5% to under 2%
• Bond prices rose dramatically
• Long-term Treasury investors earned exceptional returns

The COVID Crash (March 2020):

• Markets crashed, yields spiked briefly
• Then the Fed cut rates and started QE
• 10-year yield fell from over 1% to under 0.5%
• Bond prices soared to all-time highs

The 2022-2023 Rate Hike Cycle:

• The Fed raised rates from near zero to over 5%
• Bond prices fell significantly
• Then as inflation moderated, rates expectations shifted
• Bond prices recovered as investors expected rate cuts

These examples show how dynamic the relationship between rates and yields is. Understanding it helps investors navigate market cycles.

Conclusion: The Symmetry of the Relationship

The relationship between interest rates and bond yields is symmetric:

• When interest rates rise, bond yields rise and bond prices fall
• When interest rates fall, bond yields fall and bond prices rise

This is one of the most reliable relationships in finance. It stems from basic supply and demand principles, the time value of money, and the way markets price risk and return.

For bond investors, understanding this relationship is crucial for:

• Making informed buying and selling decisions
• Managing interest rate risk
• Building diversified portfolios
• Interpreting market conditions and economic signals

By understanding why bond yields go down when interest rates go down, you gain insight into one of the foundational mechanisms of financial markets and can make better investment decisions as a result.