Factors Affecting Bond Prices

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Factors Affecting Bond Prices
When interest rates rise, bond prices fall, and vice versa. (savings bonds image by Stephen VanHorn from Fotolia.com)

Factors affecting bond prices can be market-wide or issuer-specific. Market-wide factors affect all bonds in a particular category or group more or less to the same degree. Issuer-specific factors affect a particular bond or all bonds of a particular issuer.

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Interest Rates

When interest rates rise, bond prices fall, and vice versa, because interest, once expressed as a percentage of principal, is set in dollars. For example, if you buy a 5 per cent coupon bond, it will pay £32 for every £650 in principal until maturity. If interest rates rise to, say, 6 per cent and you want to sell, your bond's price will have to be adjusted to £541 to yield 6 per cent ($50 ÷ £541 X 100 = 6 per cent). The opposite is true when interest rates fall.

Credit Ratings

At issuance, every bond gets a credit rating from a credit rating agency based on the issuer's ability to repay. Higher rated bonds command higher prices (have lower yields). But an issuer's ability to repay may change over time. If the credit rating is lowered, the price of the bond will fall. Just a rumour or fear of a downgrade can send a bond's price lower.

Company/Issuer Risks

Credit rating agencies have been notoriously slow to respond to sudden changes in companies' situations. An oil spill, deadly drug side effects or an accelerator pedal problem are some of the examples of specific company risks that can jeopardise a company's financial health and negatively impact its bond prices.

Economic/Market Risk

Issuer ability to repay changes with changing economic conditions. In a strong economy, when companies are generating a healthy cash flow, bond investors have little to worry about. In a downturn, some weaker issuers may have difficulty generating enough cash to cover interest payments. As a result, investors seek riskier higher yielding bonds in a strong economy, bidding up their prices, and shun them in downturns, depressing the prices. Conversely, in a downturn, demand grows for safe havens such as U.S. Treasuries, pushing their prices up. When the economy picks up, investors sell Treasuries to buy stocks.

The boundary between economic and market risk is often blurred. Economic risk implies a known state of affairs---i.e., a downturn has been confirmed. But markets always look forward 3-6 months, acting in anticipation. Bonds may decline long before the official numbers are released and start rising ahead of any official recovery.

Market Psychology

Investor attitude toward risk changes constantly. Even if the underlying conditions do not change, prices of bonds may fluctuate based on investor perceptions and outlooks. Risk perception may affect specific issuers or sectors or countries.

Temporary vs. Permanent Changes

At maturity, bonds are paid in full. The only time investors can get less than the face value is if the issuer defaults or goes into bankruptcy. Otherwise, if they hold the bond till maturity, bond holders don't have to worry much about bond price fluctuations. Unlike bonds, bond funds have no maturity dates. If a bond fund declines, it may or may not come back.

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