If You Hold A Bond Till Maturity
If you hold a bond to maturity, you receive the full principal amount; however, if you want to sell before maturity, you will probably find that your bond is selling at a premium or discount to that amount. Why do bond prices fluctuate? There are two primary reasons:
Credit rating changes.
When a bond is issued, rating agencies assign a rating to give investors an indication of the bond’s investment quality and relative risk of default. The first four rating categories are considered investment-grade bonds, while the lower categories are considered speculative. A bond’s rating affects the borrowing cost for the issuer. Typically, higher-rated bonds pay a lower interest rate than lower-rated bonds. After the bond is issued, the rating agencies continue to monitor it, making changes if warranted. A bond’s price will decline when a rating is downgraded and will increase when a rating is upgraded. The price change brings the bond’s yield in line with other bonds that have a similar rating; however, these price changes are typically minor if the rating changes by only one notch. But, certain downgrades are more significant and should cause you to review whether you should continue holding the bond:
- A downgrade that moves a bond from an investment-grade rating to a speculative rating
- A downgrade of more than one notch
- A series of downgrades over a short period of time
Interest rate changes.
Interest rate changes will typically cause a bond’s price to fluctuate more than credit rating changes. When interest rates rise, a bond’s price will decline, while the bond’s price will increase when rates decrease. For instance, assume you own a 10-year bond that pays a 4-percent coupon, while bonds of the same maturity currently pay 5 percent. It would be difficult to find someone willing to pay the full principal amount to receive 4-percent interest, when they could easily go and buy another bond paying 5 percent. To entice someone to purchase the bond, you would have to lower the price enough so that the bond pays the purchaser the equivalent of 5 percent. To extend the example further, suppose you own two bonds paying 4 percent—one with a five-year maturity and another with a 10-year maturity. Would you be able to get the same price for both bonds? Since the bond with the 10-year maturity is paying a lower interest rate for a longer time, you would have to discount that bond more. One of the reasons longer-term bonds pay higher interest rates is because there is more risk interest rates will change during the bond’s life.
Before selecting a maturity date for a bond, consider when you will need your principal. If you sell before the bond matures, interest rate and credit rating changes will affect the selling price, so that the bond may be worth more or less than its cost. Please call if you’d like help with your bond portfolio.