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Newsletter

2017 4th Edition (Other Editions)

BOND VALUES

Have you ever wondered why bonds change in value? Two factors affect the price of a bond:


When these items work in concert, the result can be substantial fluctuation in market values of bonds.

BOND RATINGS 

Bonds are rated by two major agencies, Moody's and Standard and Poor's. These ratings help investors determine an issuer's ability to make the required annual interest payments and to repay the principal when it comes due. 

Standard and Poor's rates bonds triple A through D, and Moody's rates them Aaa through D. As you might expect, when bonds go further down in the ratings, they carry higher risk. If the risk were perceived to be greater, the price would be lower. 

If an issuer's bond rating is increased and its bonds are now considered to carry less risk, a new investor would be willing to accept a lower current yield. This is quite logical, since the risk of default is lower. 

That does not mean that the bond issuer may reduce the interest it pays on bonds already outstanding. If you bought an 8% coupon bond at par value, you will continue to enjoy an 8% current return. 


FLUCTUATING VALUES 

If you decide to sell the bond, a buyer will be willing to pay more for it than you did because it is now considered a safer investment. Therefore, the new buyer trades a lower current yield for greater safety. 

The price he or she is willing to pay for your bond is the price that will bring current yield in line with the current yields of other similarly rated bonds. 

However, if Moody's, for example, lowered the safety rating on your bond, its value, the price you could get for it in the bond market, would drop. The new buyer would demand a higher current yield to compensate for the higher risk. 

Therefore, changes in its rating cause the market price of a bond to vary up or down. Savvy investors anticipate downgrades in ratings and these expectations may influence prices before a new rating appears. That anticipation is very difficult for the individual investor to make since he or she does not have as much information. 

Interest rates also affect bond prices but fluctuations do not affect investors who hold bonds until maturity. If other bond issuers similar to yours, because of the changing investor expectations, are forced to pay higher interest, the price of the bond you already hold will probably drop. That is because interest rates are higher. 

For example, an investor could buy a new bond with a higher coupon rate for the same $1,000 that you paid for an 8% bond. 


THE RATE/VALUE RELATIONSHIP

The change has nothing to do with either issuer's bond rating. It just reflects the fact that for some reason market conditions are making investors in general less willing to lend money to bond issuers. The issuers must offer a greater incentive in the form of higher interest to lure more investors.

Assume you buy an 8% coupon bond for $1,000 just as before, but a year later the general level of interest rates has increased to 10%. That is the going market rate. 

For your bond, which promises to pay $80 a year, to yield a 10% return to a new buyer, its price would have to fall to approximately $800 ($800 divided by $80 equals 10%.) Why is this approximate rather than precisely $800? Because the value of a bond at any given time also depends in part upon the time remaining until the bond is scheduled to mature. 

A change in interest rates will affect the current yield on a bond with 20 years before maturity for all 20 years. In contrast, the current yield of a bond only five years from maturity will be affected for only five years. Therefore, a change in interest rates affects the value or price of the bond with the longer time to maturity much more than the price of the bond that matures sooner. 

Long term investors investing in long term bonds must keep in mind that the market value of the bonds and the price they will command can vary widely if one has to sell them before maturity.