The Effect on Treasury Bonds When the Interest Rate Is Raised

U.S. Treasury securities including Treasury bonds are viewed as one of the safest investment options. The major risk involved with Treasury bonds is interest rate risk -- the change in bond values when interest rates change. As marketable securities with fixed rates of interest payments, the bond market adjusts to changing interest rates by moving the market prices of bonds up or down.

Treasury Securities

The term Treasury bonds is often used to cover the full range of debt securities issued by the U.S. Treasury. The official names for the different Treasury securities are bills, notes and bonds, depending on the length of maturity when the security was issued. All new Treasury bonds are issued with 30 years until maturity. However, a Treasury bond with 10 years left and a new 10-year Treasury note function exactly the same and will be paying the same yield-to-maturity, even if the coupon interest rates are different.

Interest Rate Risk

When market interest rates rise, the market price of bonds fall. If you bought a Treasury bond with a yield of 6 percent and the interest rate for bonds increased to 7 percent, an investor would not be willing to pay what you paid for the bond. The market price of the bond is lowered to bring the yield on the bond up to 7 percent based on the interest, or coupon rate, the bond pays. For example, a $1,000 Treasury bond has a coupon rate of 6 percent, paying $60 per year in interest. The market rate was also 6 percent, so the price of the bond was $1,000. Interest rates rise to 7 percent, so the bond price will decline until the $60 in annual interest produces a 7 percent return to an investor who buys the bond.

Bond Price Factors

Several factors determine how much the price of an individual Treasury bond declines when rates increase. For the same change in market rates, a longer-term bond falls more in price than a shorter-term bond. Bonds with high coupon rates are less affected by interest rate increases than bonds with the same time to maturity with lower coupon rates. A bond with a coupon rate higher than the current prevailing rate will be priced at a premium to the face value. Bonds trading at a premium are affected less by rising rates than bonds trading at discounts to face value.

Rising Rate Investment Strategies

Changing interest rates and bond prices affect investors buying and selling in the current market environment. If you own a Treasury bond and hold it to maturity, you will earn the yield quoted when you bought the bond and the face amount back at maturity. If you are investing money and expect interest rates to increase, plan to buy bonds with shorter maturities. Buying 30-year Treasury bonds in a rising rate environment will result in lower bond prices and lock you into to a lower yield even as rates increase.

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About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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