Bond Price Volatility

Bond Price Volatility


Bond price volatility comes as a result, mainly from two types of shocks. One is an interest rate change and the other is a credit rating change. Interest rate risk is by far the greatest factor in bond pricing fluctuations. Regardless of the issuer or the issuers credit rating, each and every bond is subject to an interest rate risk. Why? When interest rates move higher, the bond yield that a pre-existing bond has becomes less attractive. Therefore the bond price must adjust downward to compensate a buyer for the lower than market coupon. Let's take a look at an example. If you bought a 5 year bond paying 5% annual coupon payments last year and now the going market rate for the same maturity is 6%, no one will have any incentive to purchase your bond at par; therefore, you will have to lower your price to a point where the yield would be 6%.

Can you Protect yourself against Interest Rate fluctuations?

Unless you have a crystal ball predicting future movements in interest rates, it will be very hard to fully protect yourself against interest rate shocks. To minimize your risk, you can invest in shorter term maturities. The general rule of thumb is, the shorter the term to maturity, the lower the risk to bond price volatility.  I say generally because there is a phenomena known as yield curve inversion where shorter end maturities are paying higher coupons than longer term maturities. There are some general assumptions regarding interest rate fluctuations that you should be aware of:
  • Bond prices and interest rates move in opposite directions
  • Bonds with longer term to maturity are prone to higher interest rate risk.
The longer the term to maturity, the more exponential an interest rate shock will have on the price of the bond. This applies both ways. A drop in the interest rate helps the price of a long term bond greater than that of a shorter term bond.

Can rate fluctuations affect the price of my bond at maturity?

The answer to this question is simply NO. Remember, assuming that you hold a fixed rate bond till maturity, you are guaranteed a constant coupon payment to maturity and you are guaranteed par value at maturity. You will only incur gains or losses on your bond if you sell it before the maturity of the bond.

Does it ever make sense to swap out of one bond into another with a higher interest rate?

Remember, bond prices decline as interest rates go higher and visa versa. Therefore, if you bought a bond with a 5% interest rate five years ago and see the same bond offering a 7% coupon, you will be selling your bond at a loss in order to get into the bond with a higher coupon. You will essentially have to sell the bond at a price which generates a yield equivalent to that of what the 7% bond is offering. The only situation this will work in your favor is if you anticipate taking a tax loss at year end.


Credit Ratings and Bond Prices


The investor community relies on bond credit ratings to indicate the probability of whether or not the debt will be returned to the bond holder, or defaulted. Credit ratings offer two pieces of information; the probability that you will receive your investment back at bond maturity and second, the probability that you will receive your coupon payments on time. There is nothing more secure than U.S. Treasury bonds, which are backed by the U.S. government and are considered risk-less. Other bonds issued by corporations, municipalities, and state governments are rated by various credit rating agencies. The three primary rating agencies are Moody's, Standard & Poors, and Fitch. These agencies perform the extensive research on the financial strength of an entity before a credit rating is assigned.

Credit ratings affect cost of borrowing to the issuer. Obviously, a lower credit rating will imply a borrower would have to pay a higher coupon to compensate the investor for the risk. Therefore, upgrades in credit ratings will increase the price of a bond while the opposite will happen from a downgrade. Usually, these credit ratings are only adjusted one level up or down and not usually a need for any concern when this happens. However, when we start seeing multiple grade downgrades, especially below "investment grade" or below a BBB credit rating, there is most likely a cause for concern as most larger investors will have to get out as they mandated to hold only investment grade bonds.

Inflation


Inflation can have similar effects on bond price as interest rates do. During an inflationary period, bond prices may drop as investors may not be getting compensated highly enough to keep pace with inflation.  Bond price volatility at the long end of the yield curve will be higher as these bonds have a greater risk to high inflationary periods. Generally speaking, credit ratings are a clear second to interest rate shocks when we speak about bond price fluctuations. The credit market meltdown has resulted in the Federal Reserve taking drastic measures to stabilize the economy. We saw a 75 basis point increase in the federal funds rate in a matter of two months. These types of interest rate changes will continue to be a risk factor that a bond trader cannot ignore. Investors concerned with interest rate risk should think about investing in bonds with shorter term to maturity.
Tim Ord
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