People tend to think of bonds as “safe” investments because, in comparison to stock prices, bond prices may appear relatively stable. However, if you are considering investing in bonds or a bond fund, it’s important to realize that prices of these securities can – and do – fluctuate, usually in response to changes in interest rates, the economy, or both.
The easiest way to get a handle on bond basics is to first look at how they work in a stable environment. Then, you can factor in the impact of various events and learn how they can ultimately affect the value of your bond investment.
Fundamentally, a bond is a debt. Bond issuers borrow a sum of money for a set period and agree to pay for the use of the money. The borrowed money is called principal, and the payments made for its use are called interest. The amount of the payments is determined by the bond’s coupon, and is typically spelled out as a percentage of the principal to be paid each year.
Let’s say a 10-year bond is issued with a 5% coupon. If you buy $50,000 worth of this bond issue, you could expect to receive 5% of each $100 of the face amount, or $2500, in interest each year.
So, in an ideal world, your bond investment would work like this:
– You buy the bond for $50,000 which is its face, or par, value.
– You hold the bond for its full 10-year term.
– Every year, you receive $2,500 in interest.
– The bond matures, and you receive your principal – the $50,000 – back. Meanwhile you have collected a total of $25,000 in interest.
Just one problem. We’re not in an ideal world! Bonds don’t necessarily sell at par value. Investors don’t typically hold bonds till maturity. And the return on a bond investment is not measured in terms of its coupon, but by its yield – which is determined by a combination of the purchase price and the coupon.
A bond’s coupon is set when it is issued and will not change. However, its yield changes over time, and this can affect demand for the bond and therefore, its price. Generally, a coupon reflects the prevailing interest rate when the bond was issued. If interest rates go up, newer-issue bonds will have higher coupons – and demand for older, lower-coupon bonds will go down.
So, if rates rise to 6% and you sell your 5% bond, you’d probably have to settle for LESS than the par value. But since the bond’s coupon still reflects the par value, someone who bought the bond would still get the same $2,500 of interest. This person would have a higher yield because the bond was purchased at a discounted price.
Now, let’s assume rates move the other way. Down to 4%, for example. People are going to be much more interested in that 5% bond. And you’ll probably be able to sell it for MORE than its par value. Anyone who buys it will still receive the same rate of interest per year, but they will have paid a higher price for it and the yield on the investment would, consequently, be lower.
Congratulations. You have just learned the most important thing you need to know about bond prices: they move in the opposite direction of yields.
– Higher interest rates drive bond prices down, but for investors who buy the bonds, they result in a higher effective yield.
– Lower interest rates boost bond prices, but mean lower yields for bond investors.
This doesn’t mean that bonds are riskier than stocks. The value of your bond investment will fluctuate over time, but hopefully, now that you understand why it happens, it won’t be a source of concern. After all, what you should be looking for with a bond investment is a regular amount of interest income, more than you could expect from a CD (and the price on a CD does not move).
If you want an investment that is likely to grow in value over time, jump to an article that explains how stocks work – and be prepared for a lot more ups and downs!