Investment choices - Bonds (II)
April 24, 2007Thanks for visiting! If you like what you're reading, you may want to subscribe to my RSS feed.
Having read yesterday’s post, you should now know what bonds are and that their price can differ from their par (face) value depending on various (mysterious) external circumstances. You have also read that after you’ve bought a bond its price only really concerns you if you’re planning to get rid of it before the maturity date. That’s a major difference to shares, whose price determines the value of your investment. With a bond on the other hand you can be certain that you will always get the bond’s par value back (assuming the issuer doesn’t default) plus any interest that might be payable ‘along the way’. This is the major reason why bonds should only constitute a small percentage of your portfolio while you’re young (i.e. you should make the most of your money rather than sit on a close-to risk-free bond)…
So what is it that influences the price you can sell your bond for?
- Interest rates: Rising interest rates mean you could potentially get a higher return even if your money is only sitting in a savings account. Therefore, bonds that issue after a rise in interest rates will offer a higher annual return (yield) in order to keep up with your savings account (and thus your bank!). This also means, the price for existing bonds might drop because their yield has now become less competitive and thus investors are willing to pay less. The only way to ‘convince’ investors to buy a bond with a low coupon rate, is by offering it at a discount. The same logic applies when interest rates drop - already issued bonds become more attractive and demand can only be limited via an increase in price.
- Inflation: When inflation increases, bond prices will decrease because the coupon rate might not be high enough to keep up with inflation. Especially with bonds that have a long maturity you will often find higher coupon rates to keep the bond attractive even if inflation might change substantially over the long run.
- Financial health of issuer: If the market believes that there is almost no risk of the issuer defaulting, the bond’s price will increase to reflect a high-quality security. On the other hand, if the investor is in some financial difficulties, not many people will be willing to accept the associated risk and the price will drop.
If you are keen to find out more about bonds (there is so much more material out there, trust me), I suggest you start here. There are many varieties of bonds available plus the option of investing in bond funds - i.e. a collection of bonds administered by someone who (hopefully) knows what they’re doing. The concepts are fairly similar to mutual funds so I will only cover them briefly next time.
