There are two fundamental ways that you can profit from owning bonds: from the interest that bonds pay, or from any increase in the bond’s price. Many people who invest in bonds because they want a steady stream of income are surprised to learn that bond prices can fluctuate, just as they do with any security traded in the secondary market. If you sell a bond before its maturity date, you may get more than its face value; you could also receive less if you must sell when bond prices are down. The closer the bond is to its maturity date, the closer to its face value the price is likely to be.
Though the ups and downs of the bond market are not usually as dramatic as the movements of the stock market, they can still have a significant impact on your overall return. If you’re considering investing in bonds, either directly or through a mutual fund or exchange-traded fund, it’s important to understand how bonds behave and what can affect your investment in them.
The price-yield seesaw and interest rates
Just as a bond’s price can fluctuate, so can its yield–its overall percentage rate of return on your investment at any given time. A typical bond’s coupon rate–the annual interest rate it pays–is fixed.
However, the yield isn’t, because the yield percentage depends not only on a bond’s coupon rate but also on changes in its price.
Both bond prices and yields go up and down, but there’s an important rule to remember about the relationship between the two: They move in opposite directions, much like a seesaw. When a bond’s price goes up, its yield goes down, even though the coupon rate hasn’t changed. The opposite is true as well: When a bond’s price drops, its yield goes up.
That’s true not only for individual bonds but also for the bond market as a whole. When bond prices rise, yields in general fall, and vice versa.
What moves the seesaw?
In some cases, a bond’s price is affected by something that is unique to its issuer–for example, a change in the bond’s rating. However, other factors have an impact on all bonds. The twin factors that affect a bond’s price are inflation and changing interest rates. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices.
If inflation means higher prices, why do bond prices drop?
The answer has to do with the relative value of the interest that a specific bond pays. Rising prices over time reduce the purchasing power of each interest payment a bond makes. Let’s say a five-year bond pays $400 every six months. Inflation means that
$400 will buy less five years from now. When investors worry that a bond’s yield won’t keep up with the rising costs of inflation, the price of the bond drops because there is less investor demand for it.
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Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018