Why Bonds Fluctuate in value

Bonds will fluctuate in value opposite to the changes in interest rates, short or long term. When interest rates rise, bond values will fall and visa versa. These changing prices occur to match the bonds “yield” to the prevailing interest rates applicable to the bonds maturity date.

If the bond is backed by the US Government or another form of government such as a State or Municipality, the bond yield is low as there is very little risk of a default in payment. Therefore this type of bond is known as principal guaranteed. There is no risk to owning this type of bond short or long term IF it is held until maturity. The risks associated with selling a bond prior to maturity will be discussed later in the article.

Other bonds are issued by private corporations such as GM or Bank of America. These bonds offer a higher yield to maturity as there is a risk that they may miss an interest payment or fail to pay back the entire principle value, also known as the face amount. Moody’s and Standard & Poor’s both provide a bond rating service. A high rating is supposed to mean a high credit rating for the corporation ensuring it has the lowest risk of default. However as seen recently this is not always the case so the investor should always check with a financial advisor before purchasing a corporate bond of any kind.

In addition to the risk in default, bond investors face the risk that the current interest rates have risen since they first purchased their bonds. As mentioned in the beginning of this article, if that should happen the bond will not be worth what it was when originally purchased.

For example if bond was purchased as a new issue with a price of $100 a modest rise in rates could result in a price of $98 or less for the same bond. While a drop in rates could result in a price of $102 or more. The other factor effecting your bonds value is the maturity date. Short term (maturing in 3 years or less) bonds tend to be more volatile than bonds maturing in 10-20 years. The shorter term bonds will react more to short term interest rate fluctuations.