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Why Do Bond Prices Change? – Key Factors That Affect Bond Price

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Introduction

 

 

Why do bond prices change? In the US economy, you will notice that the market for any asset for that matter, will change on a dime. Granted, bonds are not as liquid or volatile as stocks – but what exactly causes the price to change every, hour, minute, and second. In this lesson, I will be discussing the very key factors that primarily affect bonds : changes in interest rates, maturity time frame, demand for bonds, and changes in the issuers credit.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

Changes In Interest Rates:

 

Interest rates are directly proportional to the bond yield, and sometimes, to the yield to maturity itself (Which will be further explained in another lesson) – but is inversely proportional to the bond price. Interest rates are set by two joining,yet separate entities – the US Bond Market and the Federal Reserve (US Central Bank).
The Bond market is split in two to form the primary market, where newly issued bonds are sent after they have been sold by the syndicate, and the secondary market, where bonds can be regularly bought and sold by the general masses during trading hours.

The Federal Reserve on the other hand holds what are known as “minutes” where a board members and chairmen discuss the economic climate and how to adjust the current interest rates to help facilitate the US economy’s fiscal and monetary policies. A decrease in the current interest rates are what is known in the financial world as dovish, while an increase in the current interest rates are what is known as hawkish.

 

 

Using what we discussed about the relationship between interest rates, bond yields, and bond prices………

If the Federal Reserve decided to increase the interest rate = increase bond yield = bond price decreases

If the Federal Reserve decided to decrease the interest rate = decrease bond yield = bond price increases

 

 

A press conference is usually held shortly after the announcement any changes to the interest rate policies – which typically lasts an hour. Some people believe that the press conference is actually more important than the actual policy change since most investors and traders react more so to the press conference – causing the price action to be extremely volatile, while at other times range bound – and could provide investors a lucrative trading window to play on the psychology of the market.

 

 

If you choose to sell…
A decrease in interest rates → sell bond at a premium → could make a profit

Increase in interest rates → sell bond at a discount and take a loss (harder to sell a lower coupon at face value)

Keep in mind that you could also hold on till maturity so you may receive the entire principal at face value – it all comes down to your personal preference with regard to your risk tolerance and time horizon.

Maturity And Time Frame

 

 

 

Bond Yield is often times associated with the coupon rate and tends to vary depending on length of maturity.

A general rule of thumb :

Increase maturity = higher bond yield (maturity and bond yield are directly correlated)

Interest rates fall after bond was purchased → long term bond will have a better rate guaranteed for a longer period of time → increases the bond value

Demand And Supply Of Bonds

 

 

The never faulting law of demand and supply still applies here – but in this case, we will apply them to bonds that we have in mind to invest in.

Changes in Demand

 

When demand for bonds increase, this is usually accompanied by a decrease in yield and interest rates and an increase in bond prices

Demand for bond increase → increase in bond price → decrease in yield and interest rates

 

When demand for bonds decrease, this is usually accompanied by an increase in yield and interest rates and a decrease in bond prices

Demand for bond decrease → decrease in bond price → increase in yield and interest rates

Changes in Supply

 

When supply for bonds increase, this is usually accompanied by an increase in yield and interest rates and a decrease in bond prices

Increase in supply → decrease in bond price → increase in yield and interest rates

 

When supply for bonds decrease, this is usually accompanied by a decrease in yield and interest rates and an increase in bond prices.

Decrease in supply → increase in bond price → decrease in yield and interest rates

 

Changes In Issuers Credit

 

An issuers credit is one of the most important aspects when determining if a bond is investment grade material. Investors tend to rely on the investment score of bond rating agencies such as the S&P, Fitch Ratings, and Moody’s Credit Survey – all based on their grading rubric. They practically take a bond you are interested in, do some quick fundamental analysis – which includes looking at their previous financial performance, and render a verdict. But it should be known that you should consult with other rating agencies as well. It also should be noted that credit ratings may at times inaccurately assess a bond under changing circumstances, so it is important to assess the bond thoroughly before risking any capital. Should you have any questions or are unsure of where to start, consult with a bond specialist or rating agency for more guidance.

The general rule of thumb is………

Issuers less likely to default on a bond → safer with lower yield or coupon rate

Riskier bond issuers → higher yield or coupon rate

 

 

 

Treasuries (Government issued bonds) and Municipalities (local/state issued bonds) tend to be safer due to their track record and the legitimacy and comfort of knowing that you will most likely receive the principal in full, and therefore, will provide investors with a lower yield and coupon rate. Corporations however, are a little more risky, since companies can go bankrupt at any time. To solve this, corporations offer higher coupons and yields to entice investors into investing in their company – with a higher risk comes a higher reward.

 

Quick Recap

In Review…….

Bond Prices Change Because Of These Factors

Interest Rates

  • Interest rates are directly proportional to the bond yield, and sometimes, to the yield to maturity itself – but is inversely proportional to the bond price
  • Interest rates are set by two joining,yet separate entities – the US Bond Market and the Federal Reserve (US Central Bank)
  • The Federal Reserve on the other hand holds what are known as “minutes” where a board members and chairmen discuss the economic climate and how to adjust the current interest rates to help facilitate the US economy’s fiscal and monetary policies
  • A decrease in the current interest rates are what is known in the financial world as dovish, while an increase in the current interest rates are what is known as hawkish
  • Using what we discussed about the relationship between interest rates, bond yields, and bond prices………If the Federal Reserve decided to increase the interest rate = increase bond yield = bond price decreasesIf the Federal Reserve decided to decrease the interest rate = decrease bond yield = bond price increases

 

Maturity And Time Frame

  • Bond Yield is often times associated with the coupon rate and tends to vary depending on length of maturity
  • A general rule of thumb :Increase maturity = higher bond yield (maturity and bond yield are directly correlated)

 

Demand And Supply Of Bonds

  • When demand for bonds increase, this is usually accompanied by a decrease in yield and interest rates and an increase in bond prices

        Demand for bond increase → increase in bond price → decrease in yield and interest rates

  • When demand for bonds decrease, this is usually accompanied by an increase in yield and interest rates               and a decrease in bond prices

          Demand for bond decrease → decrease in bond price → increase in yield and interest rates

  • When supply for bonds increase, this is usually accompanied by an increase in yield and interest rates and a decrease in bond pricesIncrease in supply → decrease in bond price → increase in yield and interest rates
  • When supply for bonds decrease, this is usually accompanied by a decrease in yield and interest rates and an increase in bond prices.Decrease in supply → increase in bond price → decrease in yield and interest rates

 

Changes In The Issuers Credit

  • An issuers credit is one of the most important aspects when determining if a bond is investment grade material. Investors tend to rely on the investment score of bond rating agencies such as the S&P, Fitch Ratings, and Moody’s Credit Survey – all based on their grading rubric
  • But it should be known that you should consult with other rating agencies as well
  • It also should be noted that credit ratings may at times inaccurately assess a bond under changing circumstances, so it is important to assess the bond thoroughly before risking any capital
  • The general rule of thumb is………

Issuers less likely to default on a bond → safer with lower yield or coupon rate

Riskier bond issuers → higher yield or coupon rate

  • Treasuries (Government issued bonds) and Municipalities (local/state issued bonds) tend to be safer due to their track record and the legitimacy and comfort of knowing that you will most likely receive the principal in full, and therefore, will provide investors with a lower yield and coupon rate. Corporations however, are a little more risky, since companies can go bankrupt at any time

 

And these are the 4 key factors that causes bond prices to fluctuate on a day to day basis. I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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