Investors include fixed income securities, such as bonds,
in their
portfolio for a variety of reasons. Fixed income
securities, are generally
considered more conservative investments than equities
are. Therefore, you
may expect less price volatility from the fixed income
portion of your
portfolio. Similar to most financial markets, there are
certain factors
within the bond market that may cause the value of an
individual bond to
differ from the price at which it was purchased. The
factors that may
alter the value (or price) of the bond include changes in
interest rates
or in the credit quality of the issuer.
It is important to note that a change in interest rates or
an issuer’s
credit quality will typically have little effect on the
total return of a
bond held to maturity (barring default). These
fluctuations typically
affect the return on bonds that are sold prior to
maturity.
Interest Rates
One major factor that affects bond prices is movements in
interest rates.
An inverse relationship exists between a bond’s price and
its yield. As
interest rates rise, bond prices typically fall to bring
their yield in
line with the higher yields available in the market. For
example, let’s
assume the current interest rate in the market for a bond
maturing in five
years is 6%. Therefore, new bonds being issued will most
likely be issued
at par ($1000) and have a 6% coupon (or $60 per year in
income from coupon
payments). If prevailing interest rates rise to 7%, the 6%
bond will be
worth less because now an investor can pay par for a bond
that pays a
higher rate of interest than the one the investor
currently owns.
Therefore, the 6% bond will most likely trade at a price
below par (at a
discount).
Conversely, as interest rates fall, bond prices typically
rise to bring
the yield in line with the lower yields available in the
market. Consider
the same bond in the previous example. Assume prevailing
interest rates
fall to 5%, then the 6% bond will be worth more due to the
higher rate of
interest earned by the bondholder. As a result, the bond
will most likely
trade at a price above par (at a premium). Since bond
prices fluctuate
with the movement in interest rates, it is important to
note that the
value of a bond sold prior to maturity may be higher or
lower than the
purchase price.
Credit Quality
The credit quality of an issuer can also play a role in
determining a
bond’s value. In general, credit quality is the ability of
the issuer to
make interest and principal payments on time and in full.
If the credit
quality of an issuer begins to deteriorate, the value of
the bonds could
decline. On the other hand, if the credit quality of an
issuer begins to
improve, the value of the bonds may increase. In addition,
lower credit
quality bonds (below investment grade or non-rated bonds)
will usually
have more price volatility than higher quality securities.
There is also a link between a bond’s maturity date and
price. For changes
in interest rates or credit quality, bonds with longer
maturities
fluctuate more in price than bonds with shorter
maturities. As a result,
an investor is usually compensated for this increased
price variation with
higher yields.
You will most likely see the value of the fixed income
securities in your
investment portfolio vary from month-to-month. As interest
rates change,
the prices in the bond market are bound to fluctuate. In
addition, the
credit quality and maturity can also affect the value of
the bond. It is
important to consult a qualified financial professional
when evaluating
the fixed income securities in your portfolio, in light of
your investment
objective.
C. David Petrucci, CFP(r) is a Associate
Vice-President-Investments of Legg
Mason Wood Walker, Inc., a diversified securities
brokerage and financial
services firm that is a member of the New York Stock
Exchange, Inc. and
SIPC.
Direct: 301 663.8833
Toll Free: 800 634.0072
Fax: 301 663.4798
Email: cdpetrucci@leggmason.com
Visit my Web Site:
www.davidpetrucci.com
Advice from David…
Think strategically. Invest wisely.
