Like many other investments bonds fluctuate in value. There are four things that make a bond price fluctuate: interest rate, credit risk, liquidity risk, and prepayment risk.
The number one factor in bond value fluctuation is the movement of the interest rate.
Interest rates and bond prices have an inverse relationship- meaning that if interest rises bond prices drop and if interest drops bond prices rise. This is known as interest rate risk.
Let’s say that an investor buys a $100 bond that pays 5% interest. Interest rates rise and now a new bond issued pays 6% interest. Now if the investor wishes to sell the bond, a 5% interest rate bond is less attractive since a higher yielding bond is available so, this makes the 5% bond less valuable.
Now, assume the opposite. Suppose that interest rates on new bonds was down to 4%. The 5% bond now increases in value since only lower yielding bonds are now available. Now the investor could sell the 5% bond for more money since other investors would pay more for a higher interest rate.
One cannot forget to factor the time element in here. The best way to describe the time factor is: Short-term bonds and bonds close to maturity are usually less effected by interest rate changes than are long term bonds.
Credit risk is the next most influential part of bond value fluctuation. This refers to a companies ability to make principal and interest payments on time. Rating companies such as Standard and Poor’s and Moody’s Investors have their own rating systems; but generally, the higher the rating the more likely the payments will be on time.
Credit quality ranges from the highest quality AAA to below investment grade of BB and lower. Lower grade bonds generally pay a higher yield to compensate for the lower rating.
Liquidity risk refers to a situation when there is no active trading market for the bond. In these times it can be difficult to buy or sell the bond at or near its fair value. In this type of market situation a bonds price may drop drastically.
Then there is prepayment risk which is generally associated with mortgage backed bonds and asset backed bonds. In these types of bonds if interest rates fall then homeowners may refinance and pay off mortgages early.
There are other risks associated with bonds but overall bonds are a secure investment. Check out bonds, bond funds, investments,and treasury direct in your search engine for ore information on bond and bond fund investments.