An Investor’s Guide to Bond Prices
What causes a bond's price to fluctuate?
The price of a bond on the secondary market is quoted as a percentage of the bond’s face value. Should an investor plan to hold a bond to maturity, they does not need to worry about price movements since he will be repaid in full at maturity unless the issuer of the bond defaults. On the other hand, they might need to sell bonds before they mature, for a variety of reasons. Therefore, it is paramount to understand the factors that drive pricing and performance of bonds on the secondary market.
The value of the bond may fluctuate daily, especially under the influence of:
- The financial health of the company or the public authority that issued the bond. If it decreases dramatically during the term of the bond, the value of the bond will fall. On the other hand, if the issuer’s financial health improves, the value of the bond will rise. Event risks: mergers, acquisitions, leveraged buyouts and major corporate restructurings are all events that put corporate bonds at risk.
- Changes in market interest rates. When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. For example, an individual may have a 3-year obligation of EUR 10,000, with an annual interest of 4%. If market interest rates are around 2%, many people will want to buy back their bond for more than the EUR 10,000 that the investors initially paid as they stand to see a greater return. The opposite also applies
- Credit or default risk. In case where an issuer defaults and fails to return the bond principal with interest, bond prices tend to fall, as these bonds become less desirable to investors. Of course, as prices fall, yields rise, creating opportunities for investors who know what they are doing. Defaults are rare, but they can happen.
- Call or early repayment risk. Companies may call a bond when interest rates drop, allowing the company to sell new bonds paying lower interest rates and saving the company money. This option can create uncertainty regarding the lifespan of the bond, which in turn can affect the price of the bond. It is important to note however that not all bonds are callable.
- Lack of liquidity is the risk that an investor will not be easily able to find a buyer for a bond they need to sell.
- The price investors pay for a bond on the secondary market depends on supply and demand.
Below and above par
A bond with a price above 100% is rated 'above par', and a bond quoted below 100% is rated 'below par'. It follows that a bond with a price at 100% is a bond with a price ‘at par’.
To best describe this term, let’s imagine a scenario:
An investor purchased a bond with an interest rate of 5% at the price of EUR 1,000 at par on 1 June and the coupon date is 1 January the following year.
In this case, the seller of the bond would be entitled to 6 months of accrued interest. The buyer will therefore have to pay the sum of EUR 25 of interest to the seller on top of the bond price. The full accrued interest for 12 months would be EUR 50, and the amount due in this transaction reflects the holding period of 6 months.
Bear in mind that bonds are quoted at a price that does not take into account the accrued interest. They should therefore consider the price of the bond, its duration, rating, the interest rate displayed, and the accrued interest when they plan to buy a bond.