What are the factors that affect bond prices?
Bonds are a kind of fixed-income security. When you buy a bond, you lend your money to a company or government (the issuer) for a set period of time. In return, the issuer pays you interest.
All investments carry some amount of risk, so it’s helpful understand the common risks of bonds before you purchase. The price of bonds can be affected by four risk factors:
- Interest rate risk
One of the risks of bonds is that if you plan to sell abondbefore it matures, you’ll need to consider interest rates. In general, when interest rates rise,bondprices fall. When interest rates fall, bond prices rise. Bonds have an inverse relationship with general interest rates.If the rate on your bond is higher than general interest rates, then your bond is still likely to be attractive to investors. But if you need to sell a bond before itsmaturity date —while interest rates are high — you may end up selling it for less than you paid for it.
- Inflation risk
Inflation risk is the risk that the return you earn on yourinvestmentdoesn’t keep pace withinflation. This kind of risk affects many kinds of investments, but it is particularly relevant for bonds.
In general, wheninflationis on the rise, bond prices fall. When inflation is decreasing, bond prices rise. In other words, when your bond matures, the return you’ve earned on your investment will be worth less in today’s dollars. That’s because rising inflation erodes the purchasing power of what you’ll earn on yourinvestment.
For example, if you hold a bond paying 3% interest and inflation reaches 5%, your return is actually negative (-2%), when adjusted for inflation. You’ll still get yourprincipalback when your bond matures, but it will be worth less in today’s dollars.Inflation riskincreases the longer you hold a bond.
- Market risk
This is the risk that the entire bond market declines. If this happens, the price of your bond investments will likely fall regardless of the quality or type of bonds you hold. If you need to sell a bond before its maturity date, you may end up selling it for less than you paid for it.
Because of market risk, it’s important to consider your time horizon when purchasing a bond or any other type of investment. If there’s a chance you might need the money sooner, then consider a shorter time horizon.
All other things being equal, longer-termbonds tend to have higher returns and higher risk than shorter-term bonds. That’s because the longer you hold a bond, the more it could be affected by changes in interest rates, inflation and market declines.
- Credit risk
Credit ratingagencies assign ratings to bond issuers and to specific bonds. A credit rating can provide information about anissuer’s ability to make interest payments and repay theprincipalon a bond. In general, the higher the credit rating, the agency considers the issuer more likely to meet its payment obligations. If an issuer’s rating goes up, the price of its bonds will rise. If the rating goes down, the price will drop. An issuer’s credit rating can change over time.
Why is monitoring interest rates important?
When you invest in a bond, you are lending your money to a corporation or government. In return, you get a fixed rate of interest on your original investment. Bonds are often considered a way to manage the level of overall risk in an investment portfolio, because they are a fixed-income investment.
But you will want to pay attention to the risk posed by interest rates. In general, when interest rates rise, bond prices fall. When interest rates fall, bond prices rise.
It may be helpful to monitor the interest rate announcements from Bank of Canada to determine the impact on your personal financial situation.
- When interest rates fall
If interest rates fall and you decide to sell a bond, you may receive more for it than you paid.
For example, let’s say youinvest$5,000 in a five-yearcorporate bond. It pays interest at 6%. After two years, interest rates drop to 5%, and you decide to sell the bond for $5,138.
Thistable shows your return oninvestment:
| Increase in value of bond | $138 |
| Interest earned overtwo years | + $600 |
| Total return on investment | =$738 |
If you don’t sell, you’ll keep getting interest payments. However, if you reinvest that money, you’ll make less interest on it.
- When interest rates rise
When rates are up, you’ll likely get less for your bond than you paid for it. In other words, you’ll be selling it at adiscount.
For example, let’s say you buy a five-year, $5,000 bond. It pays 6% interest like in the example above. After two years, interest rates rise to 7%, and you have to sell your bond for $4,867.
Thistable shows your return on investment:
| Decrease in value of bond | – $133 |
| Interest earned overtwo years | + $600 |
| Total return on investment | = $467 |
You’ve still earned a return on your investment, but it’s less than it would have been if interest rates hadn’t gone up.
If you don’t sell, you’ll keep getting interest payments. If you reinvest that money, you’ll make more interest on it.
If you plan to sell a bond early, monitor interest rates to time your sale. If interest rates are up, you’ll get less for your bond than you paid for it.
Why is monitoring credit rating important?
Credit ratings can change over time. If an issuer’s rating goes up, the price of its bonds will rise. If the rating goes down, the price will drop. It’s a good idea to monitor this.
In Canada, there are four main credit agencies that issue ratings. These agencies rate the issuer’s ability — in the agency’s opinion — to make regular interest payments and to pay investors back when the bond matures. Each agency has its own system for evaluating credit worthiness and its own way of assigning ratings:
Canadian federal and provincial bonds generally have low credit risk. You’ll likely get a lower interest rate on these bonds, but there’s little chance the issuer will default on a payment.
If you buy bonds from a company or government that isn’t financially stable, there’s more of a risk you’ll lose money. This is calledcredit riskor default risk. Sometimes, theissuercan’t make the interest payments to investors. It’s also possible the issuer won’t pay back theface valueof the bond when it matures.
The bonds with the highest credit risk arehigh-yield bonds, issued by companies with low credit ratings. They pay higher interest, but there’s a higher risk you won’t receive any interest payments or get back your original investment.
What are bond yield curves and how are they used?
Bond yield curves are graphs that show the yields for different maturity dates of a particular bond. Ayield curve’s shape, steepness and interest rate levels can indicate what direction the economy and interest rates are heading in.
Experienced investors may try to predict howinterest ratechanges will affectbondreturns. They use tools likeyieldcurves anddurationto help make these predictions and to decide when to hold bonds and when to sell.
There are three main types of yield curves:
1. Normal (or positive) yield curve
Under normal conditions, the yield curve slopes upward to the right. This is because long-termbonds pay higher yields than short-term bonds. When the yield curve is positive, the economy is considered to be healthy.
2. Flat yield curve
There is little difference between short-term and long-term yields. This can happen when short-terms rates are rising as long-term rates are falling. For example, a government’s central bank may increase short-term rates to slowinflation. At the same time, yields on long-term bonds may fall because of lower expectations for inflation and economic growth. A flat yield curve can indicate that the economy is in transition and is weakening.
3. Inverted (or negative) yield curve
The yield curve slopes downward to the right. This happens when short-term yields rise above long-term yields. For example, after a series of hikes in short-term interest rates to curb inflation. Investors receive a greater reward for investing in short-term bonds, and lenders are less willing to make long-term loans. This can lead to an economic slowdown or recession.
Caution:
Yield curves can be a useful forecasting tool, but there’s no guarantee that a yield curve — and therefore bond prices — will move the way you expect.
What does duration mean when comparing bonds?
Duration is a way to compare bonds with different interest rates and terms. It measures how sensitive a bond’s price is to interest rate changes. It is stated in years.
With long-term bonds, duration gives an indication of what will happen to bond prices over the years in case an investor wants to sell early.
For example, a bond with a five-year duration will decrease 5% in price with each 1% increase in interest rates. The same bond will increase 5% in price with each 1% decrease in interest rates.
How can you manage risks of bond investing?
There are two main strategies to manage the risks associated with bond investing: creating a bond ladder, and diversification.
- Bond laddering
One way of reducinginterest rate riskis to buy bonds thatmatureat different times. This is known as creating a ladder orladdering. Like creating a ladder with multiple rungs that you climb gradually, a bond ladder would be composed of multiple bond investments. Some would mature sooner and others after several years.
Laddering can help reduce the risk that all your bonds will mature at a time when interest rates are low. It also frees up cash at different times, which you can choose to reinvest or use as income.
- Diversification
There are different ways to diversify your portfolio. You could choose different types of investments and/or choose similar investments with different features.
By choosing a mix of bonds with different features, you’ll increase the chance that some of your bonds will perform well at times when others do not. Consider buying a mix of bonds that fit with your financial goals and tolerance for risk. This could include a mix of government and corporate bonds, bonds that mature at different times, or morecomplex bondslike strip bonds orreal return bonds.
Learn more about checking yield curves from the Bank of Canada.
