WiseAlpha’s educational series: Teaching you everything you need to know about the bond market and more.
People often get confused about how bonds prices can change, so we’re here to help.
We have already covered the basics of bond pricing in a previous post, highlighting the fact that the price of a bond on the secondary market is quoted as a percentage of the bond’s face value. This means that if you plan to hold a bond to maturity, you don’t need to worry about price movements since you will be repaid in full at maturity unless the issuer of the bond defaults.
But in reality, you might need to sell bonds before they mature, for a variety of reasons — including a need for diversification, portfolio re-balancing, or liquidity. So, it’s important to understand the key factors that drive pricing and performance of bonds on the secondary market.
When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. Interest rate risk is the risk that changes in interest rates (in the U.K. or other world markets) may reduce (or increase) the market value of a bond you hold. Interest rate risk increases the longer the maturity of a bond.
Bond fund managers face the same risks as individual bondholders. When interest rates rise — especially when they go up sharply in a short period — the value of the fund’s existing bonds drops, which can put a drag on overall fund performance.
Duration risk is the name economists give to the risk associated with the sensitivity of a bond’s price to a one percent change in interest rates. Although stated in years, duration is not simply a measure of time. Instead, duration signals how much the price of your bond investment is likely to fluctuate when there is an up or down movement in interest rates. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates.
Credit or default risk
This is the risk that an issuer will default, failing to return the bond principal with interest. Defaults are rare, but they can happen.
Returns received by bond investors are influenced by the credit quality of the issuers whose bonds they hold. Issuers viewed as more creditworthy pay a lower yield on their bonds than issuers regarded as less creditworthy.
Ratings agencies such as Standard & Poor’s and Moody’s measure the credit risk of issuers and their bonds by assigning credit ratings. These serve as a guide to help investors understand credit quality and make qualified decisions about which bonds they should include in their portfolios. Ratings downgrades tend to lead to bond prices falling, as bonds become less desirable to investors. Of course, as prices fall, yields rise, creating opportunities for investors who know what they’re doing.
While ratings are certainly a valuable reference point, they should not be taken as gospel. When thinking about credit risk, it’s always handy to bear in mind ‘the 5 Cs’. This multi-pronged approach incorporates qualitative and quantitative measures to assess an issuer’s creditworthiness.
Call (early prepayment) risk
The majority of high yield bonds are callable, entitling companies to repay their bonds after a certain period of time has elapsed, and sometimes with a price penalty (called a call premium). This optionality can create uncertainty regarding the lifespan of the bond, which in turn can affect the price of the bond.
This ability to prepay the bond early is similar to when a homeowner seeks to refinance a mortgage at a lower rate to save money when loan rates decline. Companies often call a bond when interest rates drop, allowing the company to sell new bonds paying lower interest rates — thus saving the company money. For this reason, a bond is often called following interest rate declines.
Inflation risk is the risk that the yield on a bond will not keep pace with purchasing power (in fact, another name for inflation risk is purchasing power risk). For instance, if you buy a five-year bond in which you can realize a coupon rate of 5 percent, but the rate of inflation is 8 percent, the purchasing power of your bond interest has declined. All bonds but those that adjust for inflation, such as TIPS, expose you to some degree of inflation risk.
Liquidity risk is the risk that you will not be easily able to find a buyer for a bond you need to sell. A sign of liquidity, or lack of it, is the general level of trading activity: A bond that is traded frequently in a given trading day is considerably more liquid than one which only shows trading activity a few times a week.
Mergers, acquisitions, leveraged buyouts and major corporate restructurings are all events that put corporate bonds at risk, thus the name event risk.
Other events can also trigger changes in a company’s financial health and prospects, which may trigger a change in a bond’s rating. These include a criminal investigation of possible wrongdoing, the sudden death of a company’s chief executive officer or other key managers, or a product recall. Economic health, trade wars, and world events also are triggers for event risk.
For example right now Brexit and the type of deal the UK negotiates with the EU is a major source of event risk for the bond market.
Event risk is extremely hard to anticipate and can create uncertainty for bondholders.
Become an informed investor
As we know, several factors affect bond pricing and performance. By considering interest rate risk, credit quality, duration, and call risk, investors can make informed choices about which bonds to include in their portfolios to drive wealth creation over the long term.
As with all investments, those seeking to generate a higher return must be willing to take on more risk. Bonds with greater interest rate risk and credit risk will have more attractive yields but also exhibit more price volatility. But that doesn’t mean you should avoid them. It merely means that in the bond market, everything has its place, and everything has its price.
Please remember that bonds are investments not savings or deposit protected products and your capital and interest is at risk.
Find out more about investing with WiseAlpha. All factual information true at the time of publishing.
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