Bond prices fluctuate based on changing market sentiment and economic environments, but bond prices are affected in a very different way than stocks. Risks like rising interest rates and stimulus policies affect both stocks and bonds, but each reacts in opposite ways.
Equities vs. bonds
When stocks are on the rise, investors typically abandon bonds and flock to the booming stock market. When the stock market corrects, as it inevitably does, or when serious economic problems ensue, investors look for the safety of bonds. As in any market economy, bond prices are affected by supply and demand.
Bonds are issued initially at face value, or $ 100. In the secondary market, the price of a bond can fluctuate. The most influential factors that affect the price of a bond are the yield, going interest rates, and the bond’s rating. Essentially, a bond’s yield is the present value of its cash flows, which are equal to the principal amount plus any remaining coupons.
Yield is the discount rate for cash flows. Therefore, the price of a bond reflects the value of the yield left in the bond. The higher the total of the remaining coupon, the higher the price. A bond with a 2% yield is probably priced lower than a bond with a 5% yield. The duration of the obligation has a greater influence on these effects.
For example, a bond with a longer maturity usually requires a higher discount rate on cash flows because there is an increased longer-term risk to the debt. Additionally, callable bonds have a separate calculation for the call-day yield using a different discount rate. The yield on purchase is calculated quite differently from the yield to maturity, as there is uncertainty as to when principal repayment and coupons expire.
Changes in Interest Rates, Inflation, and Credit Ratings
Changes in interest rates affect bond prices by influencing the discount rate. Inflation produces higher interest rates, which in turn requires a higher discount rate, thus lowering the price of a bond. Longer-dated bonds see their price fall more drastically in this case because, moreover, these bonds face inflation and interest rate risks over a longer period, increasing the discount rate necessary to assess future cash flows. Meanwhile, falling interest rates also lead to lower bond yields, thus raising the price of a bond.
Credit risk also contributes to the price of a bond. Bonds are rated by independent credit rating agencies such as Moody’s, Standard & Poor’s and Fitch to assess the risk of default of a bond. Bonds with higher risk and lower credit ratings are considered speculative and offer higher yields and lower prices. If a rating agency downgrades a particular bond’s rating to reflect more risk, the bond’s yield must rise and its price must fall.