For something that is supposed to be the safe — often considered “boring” — side of your investment portfolio, bonds can get a little complicated. That may be one of the takeaways you got from my last video: What’s the scoop on bond investing? Bear with me … and welcome to part two of this subject: What’s the scoop on bond values? If bonds are supposed to be so “safe,” why do my bonds or bond funds sometimes decline in value?
Today, let’s talk about bond valuations. As I covered in my video titled “What’s the scoop on Bond Investing?”, a bond is basically a loan of your principal with interest due. So why – and how – do bond values fluctuate?
Let’s start with a super simple illustration. Say you lend your friend $100 for five years. She agrees to pay you 2% annual interest on the loan, or $2/year, and to pay back your $100 of principal at the end. After five years, you get your $100 back, plus you’ve received $10 in interest.
A bond basically works the same way: You lend an entity some money. They pay you interest and return your stake at maturity – 5 years.
Now let’s get to some differences. With your friendly loan, or “primary bond,” there are no complications. You and your friend strike a deal and, unless she’s a deadbeat, she honors it. End of story.
With real bonds, there’s a “part two” to the story: Something we financial folks call a “secondary market,” where vast numbers of investors are buying and selling primary bonds based on their market values at the time.
Imagine if your friendly loan worked like the secondary bond market did. In that weird scenario, you could take the loan your friend owes you, and sell it to your neighbor. He, in turn, might sell it to his cousin. And so on. No matter how many times the loan holder changed hands, the terms of the loan wouldn’t change one bit. It would still yield $2 interest per year, with $100 back after five years.
Now, think about how much you would want to receive if you sold your friendly “loan” in a secondary market? You’re in for $100, and you’ll receive $110 if you hold it to term, so you’d probably want to sell it for somewhere between these two figures. But how much would your neighbor or his cousin be willing to pay for it? If a buyer and seller agree on a fair price, a deal is done and your friend who took out the loan with you is now beholden to a new lender. You have cash.
In the real secondary bond market, a bond’s valuation is the “going price” that bond buyers and sellers can agree on. But here, it’s not just you and a few friends haggling over a loan. There’s a vast gathering of bonds and bond traders setting prices, with trillions of dollars up for grabs.
If you’re holding a five-year bond that pays 2% interest, and the newest, comparable five-year bonds are offering better terms – say, 3% interest – guess what happens to the valuation of your lower-interest bond? It’s suddenly less attractive, right? If you wanted to sell it right away, it wouldn’t be worth as much on the secondary market. To entice someone to buy it instead of a 3% bond, you might even need to sell it for a bit less – or discount it –to less than its $100 face – or par – value.
The reverse can happen too. If current comparable bond rates drop to 1%, you could demand a premium for your 2% bond, asking more than par value for your suddenly sweet holding.
As you might expect, this is a simplification of what’s going on out there. There are a number of nuances that I won’t go into today. But here are the key take-aways:
And, as always, please let me know what questions you have that you want answered.
