Causes of Bond Devaluation

While bonds are often thought of as a safe investment that provides shelter from the turbulence of the stock market, they can also experience price fluctuations.  Understanding the influences on bond price and bond rating can help to understand the causes of bond valuation.

A bond is a promise to repay a debt at a fixed time in the future with interest.  Sometimes the interest accumulates until the end, and sometimes the interest is paid periodically on so-called coupon dates.  The repayment plan can vary with the bond.  In either case, a bond price is almost always some amount of money less than the ultimate repayment price, in which case the bond is said to be trading at a discount.

Imagine that a large company or a city wants to build something lasting and wants long term investment that it will repay over the life of the project.  One choice for financing is to issue a bond in exchange for up front investment.  Investors will generally not part with money for free, so the bond issuer must either agree to pay interest over time or must issue the bond for an amount of money that is less than the ultimate repayment price.  A typical bond might call for payment of quarterly interest at a rate of 3% per year, with the principle of the bond coming due at a maturity date in five years.

The value today of that bond must take into account a number of factors, but the most significant are: the amount that the bond will be worth at maturity, the amount of interest that will be paid in the twenty quarters between now and the maturity date, the relative risk that the issuer will be unable to pay the debt when it comes due, and the relative return that the investor would get by investing that money elsewhere.  All of this is complicated by the fact that the anticipated value of any money in the future must be discounted because it will presumably buy less due to inflation.  Therefore, a $1,000 bond paid in five years might only be worth about $900 today, because that $1,000 will be eroded over five years by cumulative inflation.  Because we do not know what inflation will be in the future, any attempt to value that bond today relies on making assumptions about how much less the $1,000 will be in five years.

The value of the bond also depends on the likelihood that the issuer will fail to pay.  There are a number of services that try to evaluate whether bond issuers are going to be insolvent by the time that the bond comes due, and they will frequently assign ratings to the bond issuers.  Poor financial decisions today might mean that a promise to pay $1,000 in ten years is less valuable, if there is a chance that the issuer will simply not have the ability to pay at that time.  Bankruptcy and default are always a possibility, whether a bond is issued by a company such as General Motors or a country such as Greece, both of which have defaulted on bonds in recent years.  At the moment of default, the value of the bond approaches zero.

Finally, bond values can fluctuate based on the relative attractiveness of other investments.  Frequently stocks and bonds will move in different directions, as the market factors that make people believe that stocks are valuable asset make them sell bonds to buy stocks.  In addition, investments such as real estate, gold or other precious metals, or cash might be more attractive at any given time.  Some of these relative values also depend on efforts by central banks to manipulate interest rates to keep economies balanced between inflation and recession.  If investors think that the relative risk and reward of those other investments makes them more valuable than bonds, the value of the bond will fall.

In the end, bonds are subject to numerous market influences which make the promise to pay a certain amount in the future more or less valuable today.  When the risk of default increases, or the potential for inflation seems daunting, bonds may lose relatively value compared to other investments.