If your retirement portfolio includes bonds or bond funds, you may become concerned if you hear “bond values are declining.” Does this mean you should you sell your bonds and get into something less risky? Not necessarily. To understand how fluctuations in bond values impact your portfolio, here’s a quick introduction to bonds.
What is a bond?
If XYZ Corporation wants to borrow money, it can go to the bank to get a loan, or it can borrow money from investors. When a corporation borrows money from investors, it issues a paper certificate called a bond, which states the terms by which it agrees to repay the loan and the interest rate. If investors like the bond’s interest rate and terms, they’ll buy the bond and, in effect, loan the corporation the bond’s face value.
Buying and Selling Bonds
One of the nice things about bonds is that they can be easily resold to other investors. If you decide you’d rather use the money you have tied up in a bond to buy stocks, for example, you can sell the bond and use the proceeds to buy stocks instead. The price at which a bond is sold, however, is not necessarily the price paid for it.
Bond Value Changes with Market Interest Rates
Consider a $1,000 bond with an 8% interest rate. Perhaps the bond states that simple interest is to be paid quarterly, and the bond’s face value is to be repaid in full 5 years from the original issue date.
When the bond was originally issued, 8% was very likely an acceptable interest rate given the issuing corporation’s credit rating and the prevailing interest rates at the time. A year later, however, things may change. Market interest rates may rise such that 9% is a more reasonable rate of return for that company’s bonds. Or the rates may fall.
Discounts and Premiums on Bond Prices
An investor trying to sell a bond paying 8% when the going rate should be 9% will not find anyone to buy the bond from him at face value. If he agrees to sell the bond for less than the $1,000 face value, so the fixed interest payments equal 9% of the purchase price, the investor may get someone to buy it.
For a $1,000 bond paying 8% interest, the interest payments will be $80 per year. An investor wanting a 9% return could only afford to pay $888 for the bond, since 9% of $888 equals $80 per year.
This may not seem a good deal for the original investor, but it works the other way also. If prevailing interest rates go down, then the value of the bond increases above its face value. A buyer wanting only a 7% return would pay $1,142 for the $1,000 bond since 7% of $1,142 is $80 per year.
Bond Value Changes with Issuer’s Credit Rating
A bond’s value may also change with the fortunes of the issuing company. If the issuer becomes a stronger and more creditworthy company, investors may be satisfied with a lower interest rate to hold that company’s debt. In this case, the bond could be sold for more than face value.
Conversely, if the company’s financial situation becomes shaky, investors may want a higher interest rate to compensate for increased risk, and the bond’s value goes down.
Credit rating companies such as Standard & Poor’s, Moody’s, and others assign ratings to bond issues to help investors measure the riskiness of bonds. Ratings may vary from AAA, AA, and A at the upper end to C and D at the lower end. The lower the credit rating, the higher the interest rate needed to coax investors into taking the risk that the company may default on its debt.
A Conservative Investment
In general, high-grade bonds issued by extremely creditworthy companies are considered conservative investments. By holding onto a bond until its maturity, you earn all the interest bargained for and receive your original investment back when due. Whether the value of the bond rises or falls in the open market is unimportant if you never sell it, and instead just collect the money.