On the surface, a bond seems to be an easy-to-understand security. It pays interest for a specified number of years at a specified interest rate and then redeems for a specified price. As with any marketable security, however, numerous external factors can affect the price of a bond, and changes in bond prices result in changes in bond yields.
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Market Interest Rates
Although a bond pays a stated, generally unchanging interest rate, the movement of interest rates in the bond marketplace as a whole affect the price of individual bonds. Usually, bond prices fall when market interest rates rise, and bond prices rise when market interest rates fall. The reason for this is simple. If you own a bond paying a 6 per cent interest rate and market rates rise so that newly-issued bonds pay 8 per cent, your bond will not be as attractive to new investors. The price of your bond will be discounted, or go down, to the point where the net return of your bond now equals the market interest rate. Similarly, if rates in the marketplace fall to 4 per cent, your 6 per cent bond will become more attractive, and the price will rise.
All bonds are subject to inflation risk, which is also known as purchasing power risk. In periods of inflation, money in the future is not worth as much as money currently held. For example, if the inflation rate is 10 per cent, goods will cost 10 per cent more in one year. As a bond is a promise to return money to you in the future, the money you invest now will not purchase as much in the future when you receive it. Thus, periods of high inflation can greatly move the price of your bond and, consequently, its yield.
Bond ratings reflect an outside agency's opinion of the credit worthiness of a bond issuer. A bond with a lower credit rating carries a higher risk of default and a correspondingly higher risk to the investor. As a result, investors require lower-rated bonds to pay a higher rate of interest to compensate them for the additional risk. Occasionally, the credit rating of a bond issuer can be raised or lowered, usually due to a change in the financial fortunes of the underlying issuer. As a result, the bond's yield generally changes accordingly, as reflected in the rise or decline of the bond's price.
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