Bond Pricing and Bond Risks

Posted By: Advisor Analyzer Team

Bond prices are calculated differently than stocks. While stocks trade frequently on an exchange or other market, bonds trade over the counter from a dealer’s inventory. An investors looking to obtain a bond must get a quote from the dealer, which can vary substantially per bank. Banks usually use sophisticated models that value the bond’s price as a function of interest rates, coupon payments, maturity, and credit ratings, to name a few. While we won’t go into all the factors, here are some simple examples of how these risk factors impact price.

Inverse Relationship: Interest and Price

To demonstrate the relationship between bond prices and interest rates, a simple example. Suppose you have purchased a $1,000 bond that pays $50(5%) annually. Bond prices and interest rates have an inverse relationship, meaning as one goes up the other goes down. Why?

 

Suppose interest rates were to jump to 10% annually. Investors can purchase your bond for $1,000 and earn $50 a year, or go purchase a 10% bond and earn $100 for the same investment. When given the option, the choice is fairly obvious. Therefore, the lower paying bond must come down in value for investors to be indifferent between the two. If the lower paying bond dropped in price to $500, an investor can purchase 2 bonds and earn $100 a year. However, this is a very basic example to reflect the price yield relationship of bonds and ignores the term to maturity and number of coupon payments of bonds. The actual calculations of bond prices are a bit more complex and not covered here. I’m just trying to illustrate why prices go up and down inversely to interest rates.

Maturity and Price

As the maturity of a bond increases, the period an investor’s capital is tied up increases. Therefore, longer term bonds are more volatile than shorter term bonds. They experience greater price appreciation than short term bonds when interest rates decrease, larger losses when rates increase. The logic is quite simple: investors would like to stay in a bond for a longer period if there are no other bonds that offer comparable rates, and would like to exit their position quickly when rates are significantly higher than their holdings. As a bond moves further away from maturity, the longer the commitment of capital, thus resulting in the increased volatility. To compensate for the extended holding period, long term bonds usually offer higher yields than short term notes, however, this is not always the case.

Cash Flows and Price

As the frequency of cash flow payments increase, the bond price volatility decreases. Cash flows are a source of return for bond investors, and they can be reinvested at the current level of interest. An investor who reinvests the cash flows received at a higher rate of interest is able to partially offset the loss from the bond price depreciation. However, the rate the cash flows can be reinvested is highly dependent on the yield curve structure, and it may be possible to experience a decrease in price and lower reinvestment rates.

Credit Ratings and Credit Spreads

Bond prices can fluctuate in the absence of interest rate shifts due to a firm or industry’s credit rating. Credit ratings are often provided by rating agencies such as Moody’s and S&P to reflect the overall credit quality of the borrower. These firms often asses a company’s capacity to pay their obligations, guarantees, the quality of their collateral and their ability to access additional funds. A company that obtains a higher the credit rating benefits by lowering the cost of capital of those funds. The opposite is true when a company experiences a downgrade in rating.

Treasury securities are considered risk free investments, since they are guaranteed by the government. Since corporations do not have the ability to increase taxes to satisfy payments, they must pay a higher interest rate than treasuries to compensate for the additional risk. The differences in interest represent the credit spread between corporate debt and treasuries. As the credit quality of a company deteriorates, the spread above treasuries increases, resulting in a reduction in a bond’s price. If a company experiences a credit upgrade, then the spread above treasuries narrows, leading to an increase in bond price.

Conclusion

Upon review, stocks and bonds are quite different investment vehicles. Bond prices are impacted by interest rates, number of coupon payments, credit rating and term to maturity. While nowhere near comprehensive, this article was designed to review the relationship of common risk factors and their impact on certain bond prices. The actual calculations are significantly more complex, and there are many additional factors that affect certain bonds differently. However, most investors allocate a portion of their earnings into fixed positions and understanding the basic relationship is important for all bond investors to recognize.