Why Bonds Fluctuate in value

The typical bond is a securitized loan at a fixed interest rate. As such, its profitability is highly influenced by the current interest rate environment. Interest rates are by no means the only factors that influence bond prices-particularly with respect to bonds issued by volatile corporations or unstable countries-but they are almost always among the most important.

All things being equal, if interest rates rise, bond profitability will fall, and vice versa. This is because the bondholder will be locked into loaning money at an interest rate that is either above or below what she could earn if she made a new today.

For instance, if you take out a mortgage at 10%, and interest rates rise to 15%, you have done well, because it would be more expensive to borrow the money today. By that same token, if interest rates fall, the bank is better off, because it is collecting interest at a rate it would not be able to charge today. When you buy a bond, you take the place of the bank. You bet that interest rates will at least stay the same, and hope that they will fall.

Take an example: Assume that interest rates are at 10%, and that you believe they will drop to 5% in the near future. You buy a $100 bond that pays 10% interest, thereby locking in what you hope will be the higher interest rate.

The price of the bond is $100 and in fact has to be (in this somewhat simplified example). Because interest rates are at 10%, the 10% bond interest rate only allows you to keep pace with inflation. The net present value of the stream of payments is actually zero. This is better than the -10% you would earn putting the money under your mattress, but it makes you no richer than you are today. This means that the only thing that matters is how much principle is returned. And with respect to the principle, there is no reason why you would pay more than $100 if you are only going to collect $100 at the maturity of the bond, and equally, no reason why a borrower would accept less than $100 if they are going to have to pay $100 back at maturity. Therefore, the price has to be $100.

But watch what happens as interest rates change:

Assume that you decide to sell the bond before maturity, and that interest rates have dropped to 5%. The price of a new $100 bond paying 5% will be $100, for exactly the same reason that the price of a $100 bond paying 10% was $100 when interest rates were 10%. So, if $100 today buys a stream of interest payments at 5%, then a stream of interest payments at 10% will be substantially more valuable. Not surprisingly, the price of the 10% bonds will rise to reflect this as buyers try to get hold of them and holders refrain from selling.

If interest rates had risen to 20%, however, the opposite would hold true. Instead of paying double the going interest rate, the 10% bond would now only pay half, and its price would drop as holders struggled to get rid of them, and buyers were few and far between. After all, why would anyone pay $100 for a stream of interest payments at 10% when they can pay $100 for a stream of interest payments at 20%?

Once again, there are many factors that influence the price of any bond, but interest rates play a central role, and investors would do well to consider what they think will happen to rates before they make an investment in bonds.