Your bond price changed … Did your bond?
Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
Let’s say you bought a bond for $25,000. You look at your statement today and it is worth $23,500. What happened? In most cases, the answer is simple: interest rates changed.
Bond prices and interest rates generally move in opposite directions. When interest rates rise, the market prices of existing bonds typically fall. When interest rates fall, existing bond prices typically rise.
That explains why your bond may be showing a loss. But it does not necessarily mean something has gone wrong.
THE PRICE CHANGED. DID THE BOND CHANGE?
Suppose you purchased a $25,000 bond paying a 4% coupon. Later, interest rates rise and similar new bonds are available with 5% coupons. An investor would have little reason to pay you $25,000 for your bond paying 4% when a new bond paying 5% can be purchased for the same amount. Therefore, the market price of your 4% bond falls. The lower price makes its overall return more competitive with today's higher interest rates. The bond didn't change. The market around it did.
Assuming the issuer remains able to meet its obligations, the characteristics that existed when you purchased the bond remain intact. Your coupon payment has not changed. Your maturity date has not changed. And the $25,000 face value due at maturity has not changed. What changed is what someone else would be willing to pay for your bond today. That distinction matters.
BONDS ARE DIFFERENT FROM STOCKS
Investors often think about bonds the same way they think about stocks, but the two investments serve different portfolio purposes, are fundamentally different, respond independently to economic conditions, and have dissimilar evaluation methodologies. You might buy a stock at $10 per share hoping it eventually rises to $20 or $30. An increase in market value can be an important part of the reason for owning the stock.
Individual bonds are different. For many investors, the objective is not to sell the bond at a higher price. It is to generate income, preserve principal and provide predictable cash flow. If you purchase a $25,000 face value bond and hold it until maturity, the issuer is obligated to return the $25,000 face value at maturity, assuming it does not default. Between today and that maturity date, the bond's market value might be $23,500, $25,000 or $27,000. Those prices matter if you need or want to sell the bond, but if you intend to hold it to maturity, the day-to-day market price may be much less important. Think of it this way: the market is constantly putting a new price tag on your bond, even though you may have no intention of selling it.
IS A LOWER BOND PRICE BAD?
Not necessarily. If interest rates rise, the market value of the bonds you already own will generally decline. At the same time, the new bonds you purchase can provide higher yields and greater income. As you add those higher-yielding bonds to your portfolio, the portfolio's overall income potential can increase.
If interest rates fall, the opposite occurs. Newly issued bonds generally offer lower yields, while the higher rates locked in to your existing bonds become more attractive. As a result, the market value of those bonds may rise.
There is a tradeoff either way. Higher rates can mean lower prices on the bonds you already own but may provide better opportunities for money you have available to invest. Lower rates can mean higher prices on the bonds you already own but may provide less attractive opportunities for new money.
FOCUS ON WHY YOU OWN THE BOND
Seeing a loss on an investment statement naturally attracts attention. But for a buy-and-hold individual bond investor, market price alone doesn't tell the entire story.
Instead, ask a few basic questions:
- Has my coupon payment changed?
- Has my expected cash flow changed?
- Has my maturity date changed?
- Has the face value due at maturity changed?
- Has the issuer's ability to repay me materially changed?
If the answers to the first four questions are no, and the issuer remains financially capable of meeting its obligations, the bond may still be doing exactly what you purchased it to do, even though today's market price is lower.
That is one of the distinguishing characteristics of an individual bond. At the time of purchase, you can know the coupon payments, the maturity date and the face value scheduled to be returned at maturity. The price will move along the way. The anticipated result does not have to. Individual bonds are one of the only investment portfolio items where the future performance is easily calculated and highly likely. Market values change, but the contractual characteristics of individual bonds do not as long as you continue to hold the bond in your portfolio.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.
To learn more about the risks and rewards of investing in fixed income, access the Financial Industry Regulatory Authority’s website at finra.org/investors/learn-to-invest/types-investments/bonds and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) at emma.msrb.org.
