One of the hardest concepts for my Finance professor to get across is why the market price of a bond paying 5%, for example, would decrease when new bonds start being issued at 5.5%.
The class understood that they'd rather own the 5.5% bonds than the 5% bonds, and they understood that with either purchase held to maturity you get exactly the yield you paid for unless the bond defaults. The hard part was the idea that your bond yielding 5% would lose value in the resale market until its effective yield became 5.5%. E.g. depending on the duration, the 5% bond you bought for $1,000 might now be selling for $950.
So yes, the resale value of your bond will decrease as interest rates rise. But if you hold to maturity (or close) and the bond doesn't default, you get exactly what you planned to get when you bought the bond. If you sell after rates rise, you'll lose money on the trade.
The bigger concern for bond investors trying to earn a point or two above the current inflation rate (which tends to be really close to the 10y treasury bond yield) is what happens when inflation spikes a percent or two in a year and interest rates follow. If this happens and you're holding a 20-30 year bond, your bond might drop in value by 20-40%, even as it continues paying interest on schedule. Worse, your bond might be paying below the rate of inflation, meaning you're losing purchasing power every day, despite your investment.
These concerns seem salient with so many hundreds of billions of dollars plowing into bonds yielding 3%ish. If inflation hits 4 or 5% a year from now, a lot of institutions will have to mark down their assets big time - i.e. on the scale subprime mortgage portfolios were marked down in 2008.
The case could be made that an inflation surprise would terrify people out of bonds as they wait for a continuation of that inflation trend (e.g. the yield-inflation spread might widen). Who wants to catch a falling knife?
Regarding stocks, the CAPM equation (
http://www.investopedia.com/terms/c/capm.asp) to price a stock investment build's the stocks value on top of a "risk-free" baseline alternative investment yield - usually thought of as the yield on US treasury bonds. When that risk free interest rate increases, you have less incentive to buy a stock that might earn slightly higher than that. That is, when your risk free rate is 2%, you'll pay more cash for a stock investment expected to yield 5%. If that risk-free rate rose to 5% though, your risky investment that might earn 5% is worth a lot less, because the people you would sell that investment to might as well just buy the risk-free option instead of your risky option.
So rising rates could cause both stocks and bonds to fall, just as falling rates contributed to both of them rising in the past.
