Bonds are often introduced to new investors as the "safe" or "stable" part of a portfolio, which can make it genuinely surprising when a bond fund's value falls noticeably during a period of rising interest rates — as many UK investors discovered during 2022. Understanding why bond prices move the way they do, and what "duration" means in practice, is essential to using bond funds sensibly within a portfolio rather than misunderstanding what they are actually likely to do in different environments.
Why bond prices move at all
A bond is essentially a loan: an investor lends money to a government or company, which agrees to pay a fixed rate of interest (the coupon) for a set period, then repay the original amount at maturity. Once issued, a bond can be bought and sold on secondary markets before it matures, and its price on that market moves in response to changing conditions — most importantly, changes in prevailing interest rates.
The inverse relationship, explained simply
Suppose a bond was issued paying a fixed 3% coupon when that was a competitive interest rate. If the general level of interest rates in the economy then rises to 5%, this existing bond's fixed 3% payment becomes considerably less attractive compared with newly issued bonds paying 5%. To be sold at all, the older, lower-paying bond's price must fall, so that its effective yield to a new buyer (the return they will get, combining the coupon and the discount to face value) rises to something closer to the new prevailing rate. This is why bond prices fall when interest rates rise, and rise when interest rates fall — a genuinely inverse relationship.
What "duration" actually measures
Duration is a measure of how sensitive a bond's (or bond fund's) price is to changes in interest rates, expressed in years. It is not simply the time until the bond matures, though the two are related — it is a more precise measure that accounts for the timing and size of all the bond's cash flows, including coupon payments along the way.
The practical rule of thumb
A commonly used approximation is that a bond or bond fund's price will move by roughly its duration multiplied by the change in interest rates, in the opposite direction. A fund with a duration of 7 years would be expected to fall by roughly 7% in value if interest rates rose by 1 percentage point, all else being equal — and rise by roughly 7% if rates fell by 1 percentage point. This is a simplification that assumes a parallel shift in rates and ignores some second-order effects, but it captures the core relationship well enough for practical understanding.
What drives a fund's duration
- Longer-maturity bonds have higher duration. A bond maturing in 20 years is generally far more sensitive to rate changes than one maturing in 2 years, since its fixed payments are locked in for much longer.
- Lower coupon bonds have higher duration. A bond paying a smaller coupon relies more heavily on its final repayment at maturity, making it more sensitive to rate changes than a higher-coupon bond of the same maturity, which returns more of its value earlier through coupon payments.
- A bond fund's overall duration is the weighted average of all its holdings. A "short-duration" or "short-dated" bond fund holds bonds with shorter remaining maturities and will be considerably less sensitive to rate changes than a "long-duration" fund.
Government bonds versus corporate bonds
| Bond type | Primary risk | Typical behaviour in rising rates |
|---|---|---|
| UK government bonds (gilts) | Interest rate risk (duration) | Falls in price broadly in line with duration and rate change |
| Investment-grade corporate bonds | Interest rate risk plus modest credit risk | Similar to gilts, with some additional sensitivity to the issuing company's perceived creditworthiness |
| High-yield ("junk") corporate bonds | Credit risk dominates over interest rate risk | Can sometimes hold up better than gilts if rising rates coincide with strong economic growth, since default risk may fall even as rates rise |
This distinction matters because not all bond funds respond to rising rates in exactly the same way — a high-yield bond fund's price is influenced as much by the market's assessment of whether the underlying companies will actually repay their debts as by the general level of interest rates.
Why investors still hold bonds despite this sensitivity
- Lower volatility than equities, generally. Even accounting for interest rate sensitivity, bonds have historically been less volatile than equities over most periods, particularly higher-quality government and investment-grade corporate bonds.
- Diversification benefits. Bonds have often (though not always, and not reliably) moved differently to equities during periods of economic stress, providing some portfolio-level diversification even when they are not themselves risk-free.
- Income generation. Bond funds provide a relatively predictable income stream from coupon payments, which can be valuable for investors seeking regular income, discussed further in the context of income-focused portfolios.
- Eventual recovery for held-to-maturity individual bonds. A directly held individual bond, if held to maturity, will repay its full face value regardless of interim price fluctuations — though this certainty does not apply in the same way to a bond fund, which continuously buys and sells bonds and does not have a fixed maturity date itself.
A worked example
Suppose a hypothetical investor, Elaine, holds £20,000 in a UK government bond fund with an average duration of 8 years. Interest rates in the UK then rise by 1.5 percentage points over a relatively short period, in response to persistent inflation concerns.
Using the rule-of-thumb approximation, Elaine's fund might be expected to fall in value by roughly 8 × 1.5% = 12%, all else being equal, reducing her £20,000 holding to approximately £17,600 in price terms (before accounting for any coupon income received over the same period, which partially offsets the capital loss). This illustrates why a bond fund with a long average duration is not "safe" in the sense of being immune to short-term price falls — it is safe in the more limited sense of typically being less volatile than equities and carrying lower default risk than shares, not in the sense of being free from price movement altogether.
Reducing sensitivity to rate changes
- Shorter-duration bond funds. An investor concerned about the impact of near-term rate rises can choose a fund with a shorter average duration, accepting typically lower long-run expected returns in exchange for reduced price sensitivity.
- Holding to maturity where practical. Directly held individual gilts or bonds, if genuinely held until they mature, avoid the interim price volatility that affects a continuously trading bond fund, though this requires more active management than a fund.
- Understanding it as a temporary effect for a fund holding a stable duration. A bond fund that consistently maintains a certain average duration will, over time, roll over into new bonds paying the new, higher rates as older bonds mature — meaning higher rates, while painful in the short term through falling prices, do eventually feed through into higher income from the fund.
Bond funds and tax treatment for UK investors
Bond funds distributing income are subject to the same general UK tax framework as other investment income when held outside a tax-advantaged wrapper. Interest-type distributions from bond funds are generally taxed as savings income against the Personal Savings Allowance — £1,000 for basic rate taxpayers, £500 for higher rate taxpayers, and £0 for additional rate taxpayers in the 2025/26 tax year — rather than the separate £500 dividend allowance that applies to equity fund distributions. This distinction matters for an investor holding both bond and equity income funds in a GIA, since the two income types are assessed against different allowances. Holding bond funds inside an ISA or SIPP instead avoids this calculation altogether, since income within those wrappers is not subject to UK income tax as it arises, which is one reason many investors prioritise sheltering interest-generating assets inside a tax-advantaged wrapper where capacity allows.
Putting rate sensitivity in context within a broader portfolio
It is worth stepping back from the mechanics of duration to consider why an investor holds bonds at all. Bonds are rarely included in a portfolio purely for their expected return, which has historically been lower than equities over the long run — they are included primarily to reduce overall portfolio volatility and to provide a source of relatively stable income. A period of rising rates that causes bond prices to fall does not necessarily undermine this role, provided the investor's time horizon allows the bond allocation to recover as it rolls into higher-yielding new bonds over time, and provided the bond allocation was sized appropriately for the investor's actual risk capacity and time horizon in the first place, as discussed elsewhere in the context of matching asset allocation to genuine circumstances rather than reacting to any single period of market movement. Selling a bond fund purely because rates have risen and prices have fallen, without any change in the underlying reason the bonds were held in the first place, risks locking in a loss at precisely the point the fund's future income prospects (from newly issued, higher-yielding bonds it will progressively hold) have actually improved.
Key takeaways
- Bond prices move inversely to interest rates: rates up generally means bond prices down, and vice versa.
- Duration measures a bond or bond fund's sensitivity to rate changes, with longer-maturity and lower-coupon bonds generally showing higher duration.
- A useful rule of thumb is that a bond fund's price moves by roughly its duration multiplied by the change in interest rates, in the opposite direction.
- Government bonds are primarily affected by interest rate risk, while high-yield corporate bonds are also significantly affected by credit risk.
- Bonds can still fall meaningfully in price during rising rate periods, which does not necessarily mean their long-term role in a portfolio has changed.
- Shorter-duration funds reduce sensitivity to rate changes but typically come with different long-run return expectations, so this is a trade-off rather than a free improvement.