Why Bonds Fluctuate in value

Bonds are one of the most common and important investment vehicles available to the individual investor. However, because there are many types of bonds, many people are confused about how to incorporate bonds into their investment portfolios.

For the typical investor, bonds should not be viewed as an investment that has a value that fluctuates in the manner of a stock. A bond should be seen as a steady source of income that helps to balance the highs and lows of the rest of an investment portfolio. Especially for retirees, the safety of a bond makes it a very important component of overall savings; the baseline income from a bond enables the retiree to invest the rest of his money in assets that will hopefully grow faster.

Here’s an example of how a bond works. A bond is a promise by one party to pay a certain amount of interest on a predetermined schedule for a certain amount of years. These are guaranteed payments – unless the bond issuer defaults. So an investor buys that promise, and then simply sits back and collects the payments. The amount of interest varies, with safer bonds (like U.S. Government Treasuries) typically providing 3%-5% interest per year, for 1-20 years.

Investors can choose to purchase riskier bonds, and those riskier bonds carry higher rates of interest. These might be issued by a state, by a corporation, by a mortgage finance company (like Fannie Mae), or by others.

It is up to the investor to judge if he feels that the issuer will be able to fulfill the obligations in the agreement. It’s not like betting on Microsoft or eBay, where the value of the company can keep rising forever. With a bond, all you are ever entitled to is the interest rate you are promised.

However, most bonds are traded on markets, just like stocks. This happens because people buy a particular bond, and then they don’t want it or need it any more. Maybe they are nervous that the bond issuer can’t pay the debt. Maybe the interest rate from the bank has risen above the interest rate of the bond. Maybe they see a great future in biotech stocks, and they want to shift all their money.

For whatever reason, the buying and selling of bonds does make their value fluctuate. Speculators make guesses about the future value of a bond, just like they make guesses about the future of a stock. Maybe there is fear that Fannie Mae will be unable to repay its debts, and so the value of its bonds has fallen; an investor who believes Fannie Mae is rock-solid might buy those bonds. The result is that the investor has obtained Fannie Mae’s promise of a certain rate of interest, but has not had to invest as much money to get that rate.

But what is important to keep in mind is that even though the “value” of the bond has changed, the interest rate that it provides has not. If you bought a Fannie Mae bond that was paying 6% interest for 10 years, you are allowed to just keep it, and keep collecting your 6% interest. Even if the value of the bond falls, your interest rate does not. There is no reason to pay any attention to the value of a bond, if you are using it for the income that it provides.

And that is the point for most people, especially retirees. While investing in bonds can bring substantial returns, the smarter thing to do is merely the buy-and-hold strategy. Buy the bonds, and hold them to maturity (until they are completed). Use the interest that’s generated for living expenses or to increase your savings.