WHY BONDS FLUCTUATE IN VALUE

When a bond is purchased, kept until it matures, and then redeemed, the bond will be worth exactly what is stated on the face of the certificate. If instead the owner decides to sell it before it has matured, he will most likely find that the market value of the bond has fluctuated from its initial par value.

When a bond is initially sold, it is sold at a specified interest rate for a specific time period. For example, a bond might be initially sold for $1000 at a 10% rate of interest for five years. This means that the annual return would be $100. If interest rates stayed flat between the time that it was initially purchased and the time when the individual wished to sell it, the value of the bond at sale would still be $1000.

Now, assume for a moment that the typical interest rate for similar bonds has increased since the bond was purchased. Suddenly 10% does not seem like such a great deal. To make it a reasonable transaction, a knowledgeable buyer would only be willing to buy it if it was sold for less than $1000.

So suppose the going rate for similar bonds with identical duration is 11%. The annual interest paid at 10% on the $1000 bond is $100. Since the going rate is 11% this means that the bond is worth less than its face value. So, the market value of the bond becomes the dollar amount that would provide the buyer a yield of 11% interest. In this case, that would be $909.09, since 11% of this is $100.

Now let’s suppose that the interest rates for similar bonds of equal duration has gone down to 9%. Suddenly, 10% becomes a great deal. So, if the owner were to sell the bond, the purchase price would now be greater than $1000. The market value of the bond becomes the dollar amount that would provide the buyer with a 9% yield. In this case, the bond is now worth $1111.11, since 9% of this is $100.

Simply put, bond values and interest rates move in opposite directions. So, this is a clear general and mathematical answer to the question as to why bonds fluctuate, but there can be other factors as well.

One of the factors in determining the initial interest rate is the credit worthiness of the guarantor of the bond. If the financial situation of the issuing company has declined, so will the value of its bonds. The interest expected will be consistent with the current interest rate of bonds carrying similar risk.

Since there is frequently a fee associated with purchasing a bond, the length of time remaining on the bond is another factor. A bond set to mature soon is frequently less desirable than one that has greater years until maturity. Also, if the bond is subject to call by the issuing company, the bond is generally of less interest to investors.

So how does this effect the decisions you as a bondholder need to make? Most people buy bonds to hold onto through maturity. If this is your investing style, the fluctuation in bond values isn’t relevant to you.

If, however, you are interested in selling your bond and you have reason to think that interest rates are going to go up you might want to consider selling your bond before they do. If you are interested in selling your bond, but you believe interest rates are about to go down you might want to hold onto the bond for a while. Similar considerations regarding the credit worthiness of the issuer of the bond need to be made as well.