At first, bonds seem straightforward: you buy a bond, the issuer pays you interest, life is peachy. After a while, however, you notice that the bond you bought for $103 is now priced at $98. This change is driven by two primary factors within the market: interest rates and uncertainty. Understanding these factors is key when deciding which bonds to buy and how long to hold on to them.
Bonds are loans. When you buy a bond, you loan the issuing company your cash as principal. In return, the issuer pays you interest. It also agrees to pay your principal back on a particular date, known as the maturity rate. Bond interest rates can be set single rates, a series of known rates, or they can vary based on a particular set of parameters. Bond issuers can pay interest periodically for the life of the bond -- semi annually is common -- or once at maturity. All bonds are initially priced "at par," meaning that you give the issuer money equal to the value of the principal, usually expressed as $100 per bond.
Factors Affecting Interest Rate
Bond interest rates are determined by on risk. The U.S. Federal Reserve sets a base interest rate that becomes the base rate for all other borrowing within the country. U.S. Treasury securities are often priced at or near this rate, and the interest rate on other investment bonds goes up from this base with the amount of risk involved -- if there is a high possibility that an issuer will be unable to pay back the principal, the risk is higher, and therefore the interest rate will be higher. The lowest risk bonds are generally those of the U.S. government and its agencies, municipalities come next, followed by stable, established companies and finally newer, weaker companies.
Factors Affecting Price
While a bond price may initially be $100, it doesn't necessarily stay there. Bonds generally have long timelines -- several years to several decades from issue to maturity -- and a lot can happen during that time. A bond's desirability to a new buyer is wholly dependent upon what other interest rates are around. If you hold a bond issued in the mid-1990s, chances are its interest rate is much higher than a bond issued in the late 2000s. Potential buyers are willing to pay a bit more than par -- a premium -- to get their hands on a bond that pays this higher rate, so they might pay $102 per bond, rather than $100. The same goes if interest rates go up -- if your bond pays less than average, you may have to take a discount on your price -- say go down to $99 per bond -- to get out of your investment.
Factors Affecting Uncertainty
One of the nice things about bonds is that the interest rate is usually a known value, or at least a known range. This makes people feel comfortable with them, since they know what they're getting. There are some things that make investors less confident in bonds, though, and these can lower demand and prices. Issuing companies often put a "call" clause into the bond that allows them to pay it off early. If interest rates drop, this becomes more likely, as the issuer usually wants to refinance at a lower rate. Along with this, the health of the issuing company, the length of time until maturity and the current economic climate all play in to investors' ability to be more certain about the future, and about any particular bond.
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