written by: John Garger•edited by: DaniellaNicole•updated: 1/17/2011
In this first article in a series of two, factors that affect bond prices are discussed with emphasis given to interest rates, information efficiency, and book vs. market values. In addition, the risk of an investor holding a bond in a portfolio is briefly explored.
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Bonds are fixed income securities that represent debt instruments. Corporations, municipalities, and governments issue bonds to raise money for operations representing a borrowing of money from an investor. Bonds are typically less risky that stock ownership in a company because payment of bond interest takes precedents over payment of dividends to stockholders.
A corporation’s failure to pay on a bond places the company in default; this is not so with failure to pay dividends. However, the repercussions of signaling from changing or eliminating dividend payment often have detrimental effects. Read on to learn about interest rates, investment portfolios, and the factors that affect bond prices..
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Bond Interest Rates
The typical bond pays interest throughout the bond’s life with a final payment of the principal value at the maturity date. A variety of factors determines a bond’s interest rate. The most important factor is the credit worthiness of the issuer. U.S. Government bonds carry with them low risk for two reasons. First, the U.S. Government rarely defaults on a bond and second, the U.S. Government is a stable entity; it isn’t going anywhere soon.
Another factor that affects bond interest rate is current market interest rates. Changes in market interest rates cause investors to rethink the buying and selling of bonds just as it does with common stock. Finally, the maturity date of the bond affects its interest rate. For more on this, read the article on the Term Structure of Interest Rates.
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What Sets the Price of a Bond?
Many first-time investors think that since bonds represent debt whereas stocks represent ownership that bond prices are fixed. Like shares of stock in a company, bond prices fluctuate to take into account all of the information pertinent to the riskiness of owning the bond.
The most important factor that affects the price of a bond is interest rates. When interest rates rise, bond prices go down; when interest rates go down, bond prices rise. The reason, which is beyond the scope of this article, has to do with market values versus book values of bonds. Suffice it to say that there is a direct negative relationship between the price of a bond and interest rates.
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As debt instruments and fixed income securities, bonds are generally less risky than ownership in stock. However, the return on a bond is fixed whereas stock prices have no upper limit on value.
Bond prices are greatly influenced by interest rates but other factors such as the reputation and financial situation of the issuing institution play a role as well. Particularly low-risk are bonds issued by governments. The stability of the government and reputation as an institution that rarely defaults on its debt responsibilities make government bonds some of the lowest risk, but consequently lowest performing, assets in an investor’s portfolio. Bonds are often held to offset risk of riskier portfolio assets. The result is a balanced and complete portfolio of investments.
This series discusses the factors that affect bond prices and when it is a good time to buy bonds. Learn how interest rates, investment portfolios, and risk tolerance all affect when it is a good time to buy bonds.