Bonds are a form of debt security that form part of “income options” in the realm of asset classes. While bonds are typically held to maturity, some investors overlook the fact that bonds can be tradable. The tradability of bonds and factors affecting their prices make bond devaluations possible. Bond prices are affected by interest rates, credit ratings, face values, coupon amounts, and maturity dates. Of these, changes in interest rates and issuer credit ratings are primarily responsible for bond devaluations.
• Increased interest rates
Bond prices and interest rates have an inverse relationship. When interest rates rise, bond values fall and vice versa. This happens because the interest rates affect the opportunity cost of holding the bond. This is not only because other asset classes are more attractive, but also because new bonds are issued with higher coupon amounts. Thus, this condition causes existing bonds to be available at a discount (lower than current market rates).
For example, suppose a bond has a face value of $1000 and matures in one year, with a 6% yield at the face value. Six months later, the buyer wishes to sell the bond, but a new one-year bond is issued for $1000 at 10%. An investor seeking to purchase the bond would not be willing to purchase the existing bond because the yield is lower (6% versus 10%). In order for the bond to be tradable, its price would have to fall, so that the yield can increase to a value closer to the current yield on the market. Higher interest rates and high inflation reduce the demand for existing bonds, thus devaluing them.
• Credit rating changes
One of the critical factors in establishing bond prices is the reliability and financial strength of the bond issuer Recall that a bond is a loan to the issuer. Therefore, a bond’s value lies in the strength of the guarantee to repay. When the issuer is unreliable, bond prices are subject to greater fluctuations – particularly downward fluctuations.
When bonds are issues, rating agencies assign a grade to classify the bond in terms of the risk of default. Treasury bonds are investment-grade bonds (of which there are four categories) and a corporate bond issued by a company that has solvency issues would be considered a speculative bond. If bond investors buy a speculative bond, and the issuer is plunged into deeper financial woes, it would become less attractive to other investors – even though interest rates are higher on speculative bonds. This is because the likelihood of recouping the par value and coupon amount are far less likely.
According to managingmoney.com, the following credit rating changes of an issuer would devalue their bonds:
* A downgrade bond moves from investment-grade to speculative
* A downgrade of more than one notch occurs
* A series of downgrades occur over a relatively short period
• Ways to avoid bond devaluations
The merit of bonds is that devaluations do not affect them, so long as the bond issuer remains solvent. Hence, one of the ways to avoid the effects of devaluation is to select bonds that have maturity dates that coincide with the period when you want your money back. In addition, choosing bonds from reliable issuers (Treasury bonds or investment-grade bonds) can also mitigate the effects of negative fluctuations. Other strategies that help are selection of short-term bonds and using the “bond ladder” technique outlined at financialtopics.com.
Bond devaluations can occur – particularly when the market is volatile. The conditions for bond devaluation are: rising interest rates, increased inflation, and negative credit rating changes. Although bond devaluation can affect bond liquidity, there are a number of ways to avoid it. That is why bonds – particularly investment-grade bonds – remain a staple for investors.