Learn · Fixed Income · Part 2 of 3 · 4 min read
Bond prices and interest rates move in opposite directions. When prevailing interest rates rise, the prices of already-issued bonds (with their older, now relatively lower, fixed coupons) fall. When rates fall, those same older bonds — now paying a relatively attractive fixed coupon compared to what's newly available — rise in price.
Say you hold a bond paying a fixed 6% coupon. If new bonds start being issued at 8% (because interest rates rose), your 6% bond is now less attractive — nobody would pay you full face value for a bond yielding less than what's freely available elsewhere. Its price falls until its effective yield roughly matches the new 8% environment.
The reverse happens if rates fall to 4%: your 6% bond is now more attractive than anything newly issued, so its price rises.
Duration is a measure (in years) of how sensitive a bond's price is to a change in interest rates. As a rough rule of thumb, a bond with a duration of 5 years will move roughly 5% in price for every 1 percentage point change in interest rates — in the opposite direction. A duration of 1 year moves roughly 1% for the same rate change.
Longer-maturity bonds generally carry higher duration, which is why a 20-year government bond swings far more dramatically with rate changes than a 3-month treasury bill.
This is precisely why debt mutual funds are categorized by duration — Overnight, Liquid, Ultra Short, Short, Medium/Long, and Gilt, as covered in Types of Mutual Funds in India. A fund holding longer-duration bonds isn't "worse" than one holding short-duration bonds — it's simply carrying more interest rate risk in exchange for typically higher potential return, and it will swing more when rates move.
This isn't just theory — it shows up clearly in 10 years of actual return data. What Bond Yields Tell Us About Debt Funds tests exactly this relationship across Ultra Short, Short Term, Dynamic Bond, and Gilt fund categories against real bond yield data from 2015–2024 — including which categories tracked yields closely and which didn't.