Many investors do not understand the relationship between the value (value being the price they paid) of their bond holdings and the effect rising or declining interest rates have on that value. So let’s take it step by step. Say you purchased a 5.00 percent bond maturing in 2033 today at par. (Par, by the way, amounts to the face value of the bond, or, most commonly, $1000) from a new issue, and interest rates rose, the value of the bond would decline. Why? That’s a reasonable question best answered in an illustration. Let’s say that one month from now a similar new issue due in 2033 is priced with a 5.25 percent coupon at par ($1000). The 5.00 percent bond would now be worth less in the marketplace. Why? No one would be willing to pay $1000 for a 5.00 percent bond, when current rates are paying 5.25 percent. Hence your 5.00 percent have to be discounted. So the first half of the bond price rule is, when interest rates rise, the prices of bonds will generally drop.

Conversely, if you bought a 5.00 percent bond maturing in 2033 at par ($1000) and interest rates went down, the value of the bond would increase because a month from now a similar new issue would be priced at 4.75 percent coupon at par ($1000). The 5.00 percent bond would be worth more in the marketplace. No one would be willing to sell a 5.00 percent coupon at par ($1000) when current rates are paying 4.75 percent. Therefore, your 5.00 percent bonds are worth a premium. The second half of the bond rule is when interest rates decline; the price of the bonds will generally go up.

Picture it this way—the relationship between price and yield is like a seesaw. If one goes up, the other goes down.

Of course, lots of rules have some degree of exceptions. So here’s the “yeah, but…” for bonds—bonds do not all lose (or gain) the same value as interest rates rise (or fall). The longer a bond's maturity, the more it is affected by changing interest rates. A 10-year bond will usually lose more value if rates go up than a 2-year bond. The lower a bond's coupon, the more sensitive the bond's price is to changes in interest rates. A variable rate bond such as a step-up or floater will not lose as much value as a fixed rate security.

Bond prices are also affected by the credit quality of the issuer. Bond choices range from U.S. Treasury securities, which are backed by the full faith and credit of the U.S. government and are free from credit risk, to bonds that are below investment grade and considered speculative, sometimes called “junk bonds.” Clients must assess their tolerance for risk in deciding which fixed income vehicle to choose.

While interest rate changes and credit quality of the issuer affect bond prices, one thing that doesn’t change with a fixed income instrument is the income it generates. If you invest $50,000 in a bond with a 5.00 percent coupon that pays semi-annually, you would receive $2,500 a year ($1,250 every 6 months) no matter what interest rates do.

Buyers of bonds should consider themselves investors rather than traders. One buys bonds for preservation of principal and the "fixed" rate of income that it provides. While movement in interest rates will affect the present value of bonds, one's fixed income payment will never change.

Let's look at an example of bond price changes with interest changes:

Note: Above example is assuming a $50,000 investment with a 5.00 percent coupon and is for information purposes only and may not take into account call features that would affect price movement.

Most personal financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks, and cash in varying percentages depending on the investor’s age and objectives. Investors need to be aware of how changes in interest rates affect their fixed income vehicles. Fixed Income is an essential ingredient in diversifying a portfolio. For buy and hold investors, fixed income investments provide a predictable stream of payments and repayment of principal. Many people invest in bonds to preserve and increase their capital or to receive dependable interest income. Whatever your investment goals—saving for a child's education or a new home, increasing retirement income or any of a number of other worthy financial goals—investing in bonds may help you to achieve your objectives.