Stocks are risky; but bonds are safe, right? Despite this common perception, bonds, like stocks, fluctuate in value. Although they both fluctuate in value, bonds are perceived to be less risky than stocks for one key reason buying a bond means buying a promise that you will be repaid in the future.
Essentially, buying a bond means you are loaning someone money. You can buy a bond from a corporation, government, or even an individual. In exchange for your loan, the bond issuer, or borrower, will promise to pay you interest, and eventually repay the loan at some point in the future. So if a bond is just a loan, why would its value fluctuate?
Bonds have a value which fluctuates because they can be resold. The right to receive interest payments and eventually collect on the loan can be resold to someone else. This right to receive money in the future has monetary value. This monetary value, however, can fluctuate due to several factors.
The largest factor that influences a bond’s value is the credibility of the borrower. Imagine that you lent your money to a corporation and in exchange they gave you a bond promising to repay your loan while periodically paying you interest. Now imagine that the same corporation begins to experience some cash flow problems. Questions begin to arise as to whether they will be able to continue making the interest payments, let alone repay the entire loan. The value of the bond would fall because now that the repayment of the loan has become questionable, in order to resell it to someone else, you would need to offer them a discount. However, this goes both ways. You could buy a bond from someone else, for a discount, and the borrower’s situation could improve, making the bond rise in value.
Other factors that affect a bond’s value are interest rates and inflation. Since the interest payments on most bonds are fixed at the beginning, when the bond is issued, whoever holds the bond is locked into receiving that fixed interest payment. If however, interest rates across the economy rise in general, the lower fixed interest rate begins to look unattractive. In order to resell the bond to someone else, you would need to sell it for a discount to compensate for the relatively lower interest payments. The reverse holds true as well. If interest rates fell across the economy, the fixed interest rate on your bond would be higher than others, and you could therefore command a premium, selling your bond for a monetary gain.
The last important factor that affects a bond’s value is something that strikes fear into every bond investor: inflation. Anyone who lends money is frightened by inflation because by the time their loan is repaid to them, everything costs more. If inflation begins to rise, people will be less willing to lend money, or own bonds. Since fewer people want to own bonds, reselling your bond can be difficult; the value of the bond would fall, since you would need to sell it for a discount to attract a buyer.
Although bonds are essentially loans, and generally deemed a safer alternative to stocks, they do nonetheless fluctuate in value. As with any investment, there are factors to consider. Before investing in bonds, the key factors to consider are: the credibility of the borrower, interest rates, and inflation.