How Bonds Work (and Why Prices Move With Interest Rates)

What a bond actually is

A bond is a loan, just structured as a tradeable security instead of a bank agreement. When you buy a bond, you're lending money to whoever issued it—a government or a corporation—for a set period, called the term to maturity.

In exchange, the issuer promises two things: regular interest payments along the way (called the coupon), and your original loan amount back (the face value, or par value) when the bond matures.

• Government of Canada bonds: issued by the federal government, generally considered very low default risk
• Provincial bonds: issued by provinces, slightly higher yields to reflect provincial credit risk
• Corporate bonds: issued by companies, with yields that vary based on how creditworthy the company is

The coupon rate is fixed when the bond is issued and doesn't change. That fixed nature is exactly what makes bond prices sensitive to shifts in interest rates.

Why prices and rates move in opposite directions

Here's the core mechanism. Say a bond was issued paying a 3% coupon on a $1,000 face value—$30 a year. If new bonds start coming to market paying 4% because interest rates rose, nobody wants your old 3% bond at full price anymore. Why would they, when they can get a better rate elsewhere?

To make your old bond competitive, its price has to drop until the effective return—the coupon plus the discount—matches what new bonds are offering. That adjustment happens automatically in the bond market, every day, for every existing bond.

The reverse is also true. If rates fall to 2%, your old 3% bond suddenly looks attractive, and its price rises above face value because buyers will pay a premium to lock in that better coupon.

This is why you'll hear the phrase "bond prices and yields move inversely." It isn't a rule someone made up—it's simple math forcing existing bonds to stay competitive with newly issued ones.

Why some bonds move more than others: duration

Not all bonds react equally to a rate change. The main factor is how much time is left until maturity, a concept often summarized by a bond's duration.

A short-term bond—say, maturing in one year—only has to "eat" the gap between the old and new rate for a short stretch, so its price barely moves. A long-term bond, maturing in 20 or 30 years, has to absorb that gap for decades, so its price swings much more dramatically for the same change in rates.

This is why long-term government bonds and long-duration bond funds can lose meaningful value when the Bank of Canada raises rates quickly, even though they're considered very safe from a default standpoint. The risk isn't that you won't get paid back—it's that the market value of what you're holding drops while rates are higher elsewhere.

If you're choosing between bond funds, checking the fund's average duration gives you a rough sense of how much its unit price will swing when rates move.

What this means for you as a Canadian investor

Bonds show up in most Canadians' portfolios through mutual funds, ETFs, or as part of a target-date or balanced fund inside an RRSP, TFSA, or FHSA. Understanding the rate relationship helps you interpret why a "safe" bond fund can still show a loss in a given year.

If you hold an individual bond to maturity, day-to-day price swings don't affect what you eventually receive, assuming the issuer doesn't default. Bond funds are different—they hold a rotating basket of bonds and don't mature, so their unit price reflects current rate conditions at all times.

• Rising rate environment: existing bond prices fall, but newly issued bonds and reinvested coupons earn more going forward
• Falling rate environment: existing bond prices rise, but new money goes into lower-yielding bonds
• Shorter-duration bond holdings smooth out this volatility if you're rate-sensitive or need the money sooner

None of this makes bonds bad or good—it just means the price you see day to day reflects a market constantly repricing old promises against new ones. Confirm any current rates, yields, or product specifics with the issuer or your financial institution before making a decision, since these move regularly.

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