Bonds are the poor sibling of stocks for many investors. We ask for stock tips and hot stocks but you never hear about somebody offering bond suggestions at a cocktail party. Financial websites like to tout how much better stocks have performed long term compared to bonds and cash.
Due to all of that, bonds are much more of an enigma for most investors. Yet, at their heart, bonds are a simple investment tool. Where purchasing stocks gives an investor ownership in the underlying company, bonds are a way for an investor to loan money to the company in exchange for a fixed return.
If you buy a bond and hold it until it matures, you will get the specified amount of money back. However, bonds can be bought from and sold to other investors in the open market, just like shares of stock. This market allows the current value of the bond to change and allows investors other ways to make money as the value of bonds fluctuates.
The value changes because of several factors: the company, other companies, and the interest rate environment.
The company is critical to the value of a bond because it is the revenue that the company brings in that is used to repay the bond holders. If the company is seen to be in a weakening financial position, the value of the bonds will decrease because people get worried that the bonds may not be repaid or that payments will be delayed.
Other companies influence the cash value of a bond with their own bonds. Investors purchase bonds out of all of the ones that are available. The various terms on the bond impact the value in that comparison. Higher interest rates on the face of the bond are more valuable than lower interest rates. The sooner the bond matures, the more it will be worth too.
Coupon bonds that pay out interest on a regular basis are worth more than coupon-less bonds that pay at the end when they mature. Even the timing of payments will impact the value of the bond on a daily basis.
Finally, the interest rate environment will influence the value of a bond. Bonds are an investment vehicle that is very rate sensitive because of the myriad other options that will pay interest. Certificates of Deposit (CDs), savings accounts, even sweep funds offer investors ways to get interest without a lot of risk. The willingness to purchase a bond yielding 5% will be much higher if CDs are only offering 2% than if the CDs are offering 6% interest. Even the expectation of what interest rates are going to do will influence the value of bonds an expectation that interest rates are going down will increase the value and an expectation for rates to go up will lead to a drop in value for existing bonds.
As you can see from this quick introduction to why the value of bonds fluctuates, while bonds are a simple concept the investor loans money and gets repaid with interest later the specifics do complicate the understanding. Adding in the ability to trade bonds on an open market and the complexity goes up even further. This is not a bad thing. Learning what influences the value of bonds and how to trade them provides smart investors with another tool to use in their quest to make money.