Do Bonds Really Win When Rates Fall?

Headlines about the Fed entering a rate-cut cycle come up often. Naturally, attention turns to bonds. The line "rate cuts mean rising bond prices" is true, but not all bonds move the same amount. Let's walk through how short-, intermediate-, and long-duration bonds react differently, and how the choice stacks up against cash.

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Why rate moves change bond prices

Start with why rate cuts push bond prices up.

Suppose you bought a 4% coupon bond a year ago for 1 million won. Today, newly issued bonds of the same type are paying 3%. Your bond pays 1 percentage point more annually than new bonds. More people want to buy your bond. If you go to sell, you can fetch above the 1 million you paid.

The reverse: when rates rise, your existing bond's coupon falls behind new issues. To sell it, you have to drop the price. That's the inverse relationship between rates and bond prices.

So when a rate-cut cycle starts, holders of existing bonds see their bond values rise naturally. How much the prices rise depends heavily on the bond's maturity.

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Duration sets the sensitivity

The unit that measures a bond's rate sensitivity is duration. Duration captures how much the bond's price changes for a given rate move. Roughly speaking, a 5-year duration bond rises about 5% when rates fall 1 percentage point. A 10-year duration bond rises about 10%.

Duration tracks fairly closely with maturity. Short bonds (1 to 3 years) carry short duration, intermediate bonds (5 to 7 years) sit in the middle, long bonds (20 to 30 years) carry very long duration.

US short Treasuries (something like SHY) carry about 2-year duration — about 2% price rise on a 1-point rate cut. US intermediates (like IEF) carry about 7-year duration — about 7%. US long Treasuries (like TLT) carry 17- to 18-year duration — about 17% to 18%.

Same rate cut, very different price moves depending on which maturity you're holding.

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So is long-duration the best bet?

Returns alone make it look that way. Duration cuts both ways though. If rates move opposite to your expectation, the loss is just as large.

2022 is the textbook case. While the Fed hiked rapidly, long Treasuries fell about 30%. Intermediates fell about 13%. Short bonds about 4%. The longest-duration assets took the deepest losses.

Buying long-duration bonds while expecting rate cuts is theoretically the highest-return play — and the largest-loss play if your rate expectation is wrong.

One more thing to flag. Just because a rate-cut cycle starts doesn't mean bond prices begin rising the day you enter. Markets typically price in rate-cut expectations ahead of the actual cuts. By the time you read the headline, bond prices may already be elevated. If the cuts then proceed slower than the market expected, bond prices can dip temporarily.

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Comparing against cash

People often think about whether to move cash into bonds. Four options compared simply.

Cash first. Savings or a money market fund yields whatever current rates are paying. At 4%, about 4% per year. When rates fall, your yield falls with them. Principal doesn't move though.

Short-duration bonds yield similar to cash or slightly higher. A 1-point rate cut lifts prices about 2%. Some principal movement, but small.

Intermediate-duration bonds yield a bit higher than short. A 1-point rate cut lifts prices about 7%. If you can stomach moderate price movement, the result can beat cash.

Long-duration bonds yield the highest, and the price swings the most. A faster-than-expected rate-cut cycle can deliver large gains, and the reverse can deliver large losses.

Your call comes down to how confident you are about the rate timing and how much price movement you can tolerate. If timing isn't your strong suit, moving cash into short or intermediate bonds is the conservative default. If you have strong conviction, more weight in long-duration is an option.

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Government bonds versus corporates

Bonds also differ by issuer. Government bonds are issued by countries. Corporate bonds are issued by companies.

Government bond safety depends on the issuing country's credit, but US Treasuries and Korean government bonds carry effectively negligible default risk. Yields run lower than corporates of the same maturity.

Corporate bonds vary by issuer credit. Investment-grade issuers yield slightly above governments. High-yield issuers yield substantially more. Credit deterioration drops the price though.

In a rate-cut cycle, both types tend to see price increases. Corporates carry an economic component on top of rate sensitivity though. Rates can fall while a weakening economy raises default risk for companies, which drops corporate bond prices. Don't just look at the yield — check the credit rating of the issuer too.

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Wrapping up in one line

Rate cuts push bond prices up, with longer maturities producing larger price moves. Short-duration bonds are stable, long-duration bonds swing more. Confident in the rate timing — intermediate and long are attractive. Not so confident — moving cash into short or intermediate is the conservative play. Corporates carry economic sensitivity on top of rate sensitivity, so check the issuer's credit rating alongside the yield.

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• This information is not investment advice.
• Past performance does not guarantee future results.
• Backtest results are simulations and may differ from actual trading outcomes.