Interest rates have risen compared with the years before 2022. For many investors, this represents an opportunity to buy bonds, earn attractive yields and benefit from a possible future rate cut. But a flaw in reasoning can turn an apparently prudent strategy into a financial bet that is far riskier than it seems.
“I am investing one million euros in bonds because, sooner or later, interest rates will fall again.”
At least on the surface, this reasoning has an economic logic. When market yields decline, the price of existing fixed-rate bonds tends to rise. Someone buying today could therefore benefit from both regular coupon payments and a capital gain on the amount invested.
The problem is not how this mechanism works, which is entirely correct. The problem is treating a particular future path of interest rates as inevitable simply because we experienced a different situation in the past.
To understand how dangerous this belief can be, we need to examine three aspects: the history of interest rates, how the bond market works, and how investors’ expectations are incorporated into security prices.
A world of zero interest rates: normality or a historical exception?
Anyone who started investing in the decade before 2022 experienced particularly favourable monetary conditions.
After the financial crisis of 2008 and, subsequently, during the European sovereign debt crisis, the European Central Bank (ECB) progressively reduced its policy rates. Expansionary monetary policy was reinforced through asset purchase programmes, including Quantitative Easing (QE), with the aim of supporting the economy and countering persistently low inflation.
The result was an environment in which yields on many European government bonds were close to zero or even negative.
To understand the scale of these changes, we can look at the evolution of the ECB deposit facility rate.
| Reference date | ECB deposit facility rate |
|---|---|
| June 2014 | −0.10% |
| September 2019 | −0.50% |
| September 2023 | 4.00% |
| June 2025 | 2.00% |
| September 2026 | 2.50% |
The data reveal a particularly significant regime change. Between September 2019 and September 2023, the deposit facility rate increased by 4.50 percentage points, rising from −0.50% to 4.00%.
The ECB subsequently began a phase of rate reductions, bringing the deposit facility rate to 2.00% in June 2025. However, the stance changed again during 2026: with its decision of 10 September, prompted by persistent inflationary pressures, the rate was raised to 2.50%, effective from 16 September.
This pattern shows how risky it is to imagine monetary policy as following a predetermined path.
Rates can rise, fall, stabilise and subsequently change direction again. Central bank decisions depend on developments in inflation, economic activity and macroeconomic risks.
But the most interesting point emerges when we extend the time horizon further.
A study by Paul Schmelzing, published in 2020 in the Bank of England’s research series, reconstructed the evolution of real interest rates over a period extending from 1311 to 2018.
The analysis shows that real yields have not remained constant over the centuries. Instead, they have followed a long-term structural downward trend, while experiencing periods of sharp discontinuity.
It is important not to draw a simplistic conclusion from this research. On the one hand, the period of negative nominal policy rates in the euro area represents a historically unusual monetary setting. On the other, there is no universally normal level of interest rates to which the economy must necessarily return.
History proves neither that rates must return to zero nor that they must remain high. Rather, it shows that treating any particular level as inevitable is a mistake.
Why do bonds rise in value when interest rates fall?
Before assessing a bond strategy, we need to understand how the price of a security is determined.
A conventional fixed-rate bond represents a claim against the issuer. The investor pays an initial amount in exchange for the right to receive specified future cash flows, generally consisting of coupons and repayment of principal at maturity.
The theoretical price of a bond can be expressed through the following formula:
Where:
- P represents the theoretical price of the bond;
- C is the periodic coupon, assumed to be constant;
- F is the face value repaid at maturity;
- y is the yield to maturity per period;
- n represents the number of periods remaining until repayment.
The formula, valid in the simplified case of constant coupons, discounts all future cash flows using a single yield.
Its economic meaning is straightforward: one euro that we will receive in ten years does not necessarily have the same value as one euro available today.
The higher the yield required by investors, the lower the present value of future cash flows and, consequently, the price of the bond.
Conversely, a reduction in the required yield increases the present value of the coupons and the principal to be repaid.
For example, imagine holding a bond with a face value of 1,000 euros and an annual coupon of 4%, equivalent to 40 euros.
If new securities with comparable risk and maturity characteristics are issued in the market yielding only 3%, our bond becomes relatively more attractive. Investors will therefore be willing to pay more than its face value.
If, instead, the yield required by the market rises to 5%, the bond will become less competitive and its price will tend to fall.
The idea of buying bonds before a possible reduction in interest rates stems from this inverse relationship between price and yield.
However, to understand the actual risk of the transaction, we need to introduce another fundamental concept.
Duration: why two bonds can react in completely different ways
A bond’s maturity indicates when the principal is due to be repaid. Duration, by contrast, measures the sensitivity of its price to changes in market yield and is linked to the timing of its cash flows.
Modified duration provides a first approximation of the percentage change in price resulting from a change in yield:
Suppose an investor has bought bonds with a total market value of one million euros and a modified duration of 8.
If the market yield falls by one percentage point, or 100 basis points, the approximate price change will be:
The invested wealth could therefore rise, through the price effect alone, by approximately:
But the same mechanism works in the opposite direction.
A rise in yields of 100 basis points would produce an approximate fall in market value of 8%, equivalent to around 80,000 euros.
The relationship is not perfectly linear: for large yield changes, we also need to consider the bond’s convexity, which measures how price sensitivity changes as interest rates move.
This does not alter the fundamental principle: all else being equal, the higher the duration, the greater the exposure to fluctuations in yields.
A bond approaching maturity with a duration of 2 reacts very differently from a long-term security with a duration of 15.
On a portfolio worth one million euros, the latter could theoretically experience a fall in market value close to 150,000 euros following a one-percentage-point rise in yields, before considering the effects of convexity.
This is why the word “bond”, on its own, is not enough to describe an investment’s risk.
One million euros invested today: how much could we gain or lose?
To make the analysis concrete, imagine investing one million euros in a fixed-rate bond with the following characteristics:
| Characteristic | Value |
|---|---|
| Initial investment | 1,000,000 € |
| Initial remaining maturity | 10 years |
| Annual coupon | 4% |
| Initial yield to maturity | 4% |
| Initial price | 100 |
| Total annual coupon | 40,000 € |
| Initial modified duration | Approximately 8.11 |
We consider a hypothetical security with no default, annual coupons and repayment at par.
Suppose we wish to sell the entire position exactly one year after purchasing it. At that point, the bond will have nine years remaining until maturity.
What will our outcome be, depending on the yields required by the market?
| Market yield after one year | Market value of the bonds | Coupons received | Total return |
|---|---|---|---|
| 3% | 1,077,861 € | 40,000 € | +11.79% |
| 4% | 1,000,000 € | 40,000 € | +4.00% |
| 5% | 928,922 € | 40,000 € | −3.11% |
| 6% | 863,966 € | 40,000 € | −9.60% |
A theoretical simulation calculated by discounting the remaining cash flows. The results include the market value after one year and the coupon received, excluding taxes, fees, coupon reinvestment and changes in credit risk.
The example highlights something that many investors tend to underestimate.
If the yield fell from 4% to 3%, the investment would generate a total gain of around 117,861 euros, combining the price increase with the coupon received.
But if the yield rose from 4% to 6%, the value of the bonds would fall to around 863,966 euros. Even after including the 40,000 euros of coupons received, the total loss would be approximately 96,034 euros.
Clearly, buying long-term bonds with the intention of reselling them after a fall in yields is not necessarily a conservative strategy.
It is also a directional position in the interest rate market.
The real mistake: assuming that an ECB rate cut automatically produces a gain
So far, we have considered the relationship between bond prices and market yields.
But there is an even more important point: the ECB policy rate is not the same as the yield on a ten-year bond.
The ECB directly sets certain very short-term interest rates. Medium- and long-term government bond yields, however, are determined by market trading and respond to several factors.
Conceptually, we can represent the yield on a long-term government bond as:
Where:
- represents the average expected short-term interest rates over the life of the bond;
- TP is the term premium, meaning the premium required to bear the risk associated with the investment’s maturity;
- RP represents additional risk premia, including sovereign risk where relevant.
The formula is a simplified economic representation, not an exact identity that applies indiscriminately to every security.
Suppose investors already expect ECB rates to fall by 100 basis points over the next twelve months.
To the extent that this forecast is shared by the market, it will already affect bond prices, particularly through expectations of future short-term rates.
If the ECB delivered exactly the cuts investors had anticipated, a further significant rise in the prices of long-term securities would not be automatic.
The market may already have incorporated much of that scenario.
Conversely, if the ECB cut rates much faster or more aggressively than expected, bond yields could fall further, pushing prices higher, all other factors being equal.
The distinction is crucial.
It is not enough to predict correctly that interest rates will fall. To achieve a gain beyond what is already incorporated into prices, we need to understand whether they will fall more than the market expects.
It is the same principle we observe in the stock market: a company can report rising earnings and still see its share price fall if the results are below expectations.
In finance, what matters is not only what happens, but also how far it differs from previous expectations.
What if the ECB cut rates but BTP yields rose?
This apparently contradictory situation is economically possible.
Imagine the ECB cutting policy rates by 50 basis points to support the economy.
At the same time, however, investors might begin to demand a higher premium to hold long-term securities, for example because of higher inflation expectations or greater uncertainty about public finances.
If the decline in the expected-rate component were more than offset by increases in the term premium and sovereign risk, the market yield on ten-year BTPs could rise even with more expansionary monetary policy.
This phenomenon explains why we must carefully distinguish interest rate risk from credit risk and the sovereign spread.
For an Italian investor, buying a ten-year BTP does not mean taking a position exclusively on the path of ECB interest rates.
It also means exposure to changes in the yield required on Italian public debt, which depends on monetary, macroeconomic and fiscal factors.
A comparison with German Bunds, for example, allows us to observe one component of the additional compensation demanded by the market to hold Italian debt, although the spread is not a pure measure of default risk alone.
Does holding bonds to maturity eliminate risk?
At this point, one might object that a loss in value on the secondary market does not necessarily represent a permanent loss.
If we buy a fixed-rate bond and hold it until repayment, we do not need to sell it during a possible period of falling prices.
This observation is correct, but requires some clarification.
For a non-indexed fixed-rate security bought at par and repaid as agreed at maturity, the investor will receive the contractual coupons and the face value, regardless of interim price fluctuations.
However, at least three economic risks remain.
The first is credit risk: the issuer may be unable to pay the coupons or principal in full.
The second is inflation risk: repayment of one million euros in ten years does not guarantee that the amount will retain its original purchasing power.
The third is opportunity cost: if market yields rose significantly after the purchase, the investor would remain locked into less remunerative terms than those available on newly issued securities, except to the extent that coupons and other amounts becoming available could be reinvested differently.
There is also the risk of having to liquidate the investment early to meet liquidity needs.
Furthermore, holding an individual bond must be distinguished from holding a conventional bond ETF that maintains a particular range of maturities.
A bond fund generally does not guarantee repayment of a predetermined face value on a specific date. Its portfolio is renewed over time, and sensitivity to interest rates may persist.
This does not necessarily make it a worse instrument, but it changes its economic characteristics compared with directly holding an individual bond to maturity.
Nominal and real returns: the role of inflation
Imagine earning a nominal return of 4% per year, assuming an investment that actually allows us to realise it.
An investor might consider this satisfactory. However, if average inflation were 2.5%, the gross real return would be:
A nominal return of 4% would therefore correspond to effective growth in purchasing power of approximately 1.46% per year, before taxation.
If, in a simplified example, we considered the Italian tax rate of 12.5% applicable to income from Italian government securities, a nominal coupon of 4% would correspond to a net coupon of 3.5%.
On one million euros, this would mean 35,000 euros in net annual coupons instead of 40,000, before any other charges. The effective return would still depend on the purchase price, the applicable tax treatment and the full set of cash flows.
With persistent inflation, therefore, an investment that appears attractive in nominal terms might provide less protection for purchasing power than one might imagine.
When can investing one million in bonds make sense?
It would be equally mistaken to conclude that investing a large sum in bonds is necessarily a bad decision.
The assessment depends on the objective we want to achieve.
An investor who wants to build relatively predictable income streams, preserve nominal capital at specified maturities and reduce exposure to the stock market may find bonds consistent with their needs.
The situation is different for someone buying very long-term securities primarily to realise capital gains in the short term.
In the first case, the issuer’s financial sustainability, the maturity structure, the yield to maturity and liquidity needs are central.
In the second, duration, convexity, market expectations and the expected total return over a specific investment horizon become particularly important.
One possible solution for managing liquidity needs spread over time is to build a bond ladder: a series of bonds with different maturity dates.
For example, instead of investing the entire million in a single ten-year security, the capital could be allocated across maturities of 2, 4, 6, 8 and 10 years, potentially also diversifying across issuers.
This structure does not eliminate risks or guarantee a higher return. It does, however, spread repayments over time, limit concentration at a single maturity and periodically provide amounts that can be reinvested.
The actual decision should therefore arise from a comparison of potential returns, risks and financial objectives, rather than the simple belief that rates will fall “sooner or later”.
The psychological mistake: confusing the recent past with normality
Finally, a psychological component influences many investment decisions.
Behavioural finance refers to recency bias: the tendency to give excessive weight to the most recent events when forming expectations about the future.
Someone who invested mainly between 2014 and 2021 may have internalised the idea that near-zero interest rates represent the normal functioning of the economy.
As a result, when they observe higher yields, they may automatically regard them as temporary.
The same mistake can also arise in the opposite direction.
An investor who has experienced only periods of high inflation and restrictive monetary policy might consider a future return to very low rates impossible.
In both cases, the reasoning confuses an individual historical experience with a general economic rule.
The problem is not using history to make forecasts. It is using only the historical period we know best, while neglecting alternative scenarios and economic mechanisms.
Conclusion: investing in bonds does not necessarily mean investing without risk
The idea of buying bonds to benefit from a fall in interest rates is not, in itself, wrong.
It is a financial strategy that can be profitable under certain conditions.
However, its success depends on variables that we cannot treat as certain: the path of inflation, central bank decisions, the behaviour of long-term yields, changes in risk premia and the expectations already incorporated into market prices.
An investor buying one million euros of high-duration bonds should understand not only the return they could achieve in a favourable scenario, but also the potential loss they would incur if the market moved in the opposite direction.
Above all, they should distinguish between two very different questions: “What does this bond yield today if I hold it to maturity?” and “How much can I earn by reselling it if interest rates fall?”
The first mainly concerns the contractual return and the issuer’s ability to meet its obligations. The second concerns an expectation about future price movements.
Confusing them means attributing a degree of safety to an investment that it may not possess.
The fact that rates have risen is not, on its own, proof that they must fall. And the fact that a bond promises repayment of principal at maturity does not mean its value will remain stable in the meantime.
Economic history does not give us certainty about the future. Rather, it reminds us how often investors have mistaken temporary conditions for equilibria that would last.
And when investing one million euros, the difference between a reasoned expectation and an unverified belief can be worth tens, if not hundreds, of thousands of euros.
Methodological note: the numerical simulations are theoretical calculations for educational purposes and do not represent market forecasts. This article does not constitute a personalised investment recommendation.