Why Do Bonds Fluctuate in Value


August 22, 2011

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If you buy $10,000 of a bond maturing in 2015, you will receive $10,000 upon maturity in 2015. Based on current market conditions, you may have paid a price of 105 or 107 or 97 for this bond. Today, if the price is 105, the bond is worth $10,500; if the price is 107, the bond is worth $10,700; if the price is 97, the bond is worth $9,700.

Regardless of what you paid, the price of most bonds at maturity is par or 100. However, while you own the bond, the bond is going to fluctuate in value based on the current market conditions at any given time. If you hold onto the bond, you will get your $10,000 upon maturity, but along the way, the bond’s value is going to go up or down, a lot or a little. Eventually, as the bond nears maturity, it will get closer and closer to a price approaching 100. On the maturity date, the price will be exactly 100.

Since bonds have a fixed coupon rate and maturity value, the concept that a bond will fluctuate in value can be perplexing. The price that you pay for a bond is what determines its yield or your actual return. When a bond’s price goes up, its yield goes down; when a bond’s price goes down, its yield goes up. As such, as economic conditions change, your bond’s price and yield will be tied to the interest rate environment at any given time. This will not affect how much interest you get paid every six months. It will show up on your account statements as the current value of your bonds.

The part that should be less complex for you to understand is that regardless of the interim market value between now to maturity, almost all bonds will be redeemed at par value or 100 cents on the dollar.

Another extremely important concept for you to understand is this: The longer the maturity, the more sensitive a bond’s value to changes in interest rates. For instance, if I have a bond maturing 20 days from now, regardless of what happens to interest rates today, even dramatic moves, the value of the bond is going to be close to 100.

On the other hand, if you have a bond maturing in 15 years, the value of changes in interest rates will have more pronounced impact on the value of your bonds. If rates go down, your bond’s value will go up. If rates go up, your bonds value will go down.

The reason is this: Let’s say someone is selling $10,000 of Aaa-rated bonds paying 6% tax-free ($600 per year). If the bond matures in 90 days, the benefit of this high interest rate is only going to last a short while for a new buyer; as such, the price of the bonds will be close to 100. On the other hand, if someone is offering Aaa-rated bonds paying 6% maturing 10 years from now, a prospective buyer will likely pay a big premium for these bonds or much more than a price of 100. The buyer has a lot more time to collect 6% interest payments and would be willing to pay a much higher price.

If interest rates suddenly started climbing dramatically on 10-year bonds, the current market price of the 6% bonds will go down. This is because the difference between 6% and the current 10-year rates has narrowed. The prospective buyer is not going to be as willing to pay the same premium as before since new bonds of similar 10-year maturities are now paying more.

The concept of bonds fluctuating in value may still take some time for you to get used to. Do be aware that a bond’s value does not impact its value at maturity, but it may cause psychological turmoil if you open account statements that show your bond’s value to be lower than what you paid. Unlike stocks, almost all municipal bonds held to maturity ultimately end life at a price of 100.

 

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