There are two primary factors that affect bond prices ― interest rate changes and credit rating changes. Interest rate changes typically will cause a bond’s value to fluctuate more than credit rating changes.
As interest rates rise, a bond’s price adjusts down, while the bon’s price will increase when rates decrease. Simply put, bond prices and interest rates move in opposite directions. Also, bonds with longer maturity dates are more vulnerable to interest rate changes, since the difference will impact the bond for a longer time period.
Credit ratings also influence a bond’s price. When a bond is issued, rating agencies assign a rating to give investors an indication of the bond’s investment quality and relative risk of default. Typically, higher-rated bonds pay a lower interest rate than lower-rated bonds. After the bond is issued, the rating agencies continue to monitor it, making changes if warranted.
A bond’s price tends to decline when a rating is downgraded and increase when a rating is upgraded. However, these price changes are typically minor if the rating changes by only one notch. Certain downgrades are more significant, such as a downgrade that moves a bond from an investment-grade to a speculative rating, a downgrade of more than one notch, and a series of downgrades over a short period of time.
If you want to minimize the risk of price fluctuations, consider these tips:
- If you hold a bond to maturity, you’ll receive the full principal value, so you won’t be affected by any price fluctuations. Thus, consider purchasing bonds with maturity dates that match when you will need your principal.
- Consider investing in bonds with shorter-term maturities.
- Design your bond portfolio using a ladder, so you’ll have bonds coming due every year or so. This strategy typically lessens the effects of interest rate changes. Since the bonds are held to maturity, changing interest rates won’t result in a gain or loss from a sale. Bonds are maturing every year or two, so your principal is reinvested over a period of time instead of in one lump sum.
- Choose bonds that match your risk tolerance. Safer bonds, such as U.S. Treasury bonds or investment-grade corporate bonds are less susceptible to credit rating risks.
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Copyright © Integrated Concepts 2013. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.