Sunday, November 28, 2004

Why Do the Prices of a Bond Fluctuate between Issue and Maturity?

A student recently asked why the prices of previously issued bonds fluctuate even though they have a face value of $1,000 which the current owner receives when the bond matures.

Bonds are debt insturments issued by corporations and government entities. Basically, the business or government (the Federal, state, local or an agency like FNMA or entity like Pima College) has a need for a large sum of money and raises that sum by selling bonds. Bonds are usually issued in $1,000 units – that is, each individual bond has a value of $1,000. Most bonds have a fixed interest rate and are usually redeemable in 25 - 30 years (i.e., the buyer does not get their $1,000 back for 25 - 30 years). Interest is paid quarterly, semi-annually or annually for the life of the bond by the issuing authority and the principal (the $1,000 the buyer paid for the bond) is re-paid at maturity (25 - 30 years later). The interest rate is fixed and that is the rate the issuer pays to the owner of the bond during the life of the bond.

If the buyer of the bond wants her money back before the bond matures in 30 years she can sell it to another person. For instance, I may buy a bond paying 10% interest with a 30 year maturity. Five years later I need money to help pay my child's college tuition. So I sell the bond to you. While I owned the bond I received the interest payments. Now that you own it they are sent to you. If you hold the bond to maturity you will receive the $1,000 face value (i.e., what it was originally sold for) that I originally paid. But you can also sell it to someone else if you do not want to wait until maturity for your money.

While the face value of the bond does not change, the amount subsequent buyers are willing to pay does change. Interest rates are the main thing that causes bond prices to change when they are traded before maturity (there are some other factors influencing the price as well but we can ignore them for now). Assume that rates were 5% when I brought the bond and that is the rate the bond pays. Pima College or IBM or whoever issued the bond is obligated to pay $50 per year (05 * 1,000) to the owner of the bond. Now suppose five years have gone by and I want to sell this bond paying 5%, but interest rates are now 10%. You are not going to pay me $1,000 for this bond paying $50 per year when you can buy a new bond being issued by some other company or government paying the current rate of 10% or $100 per year. To get you to buy my 5% bond I have to lower the price to the point where the $50 per year being paid is equal to 10% of what you paid me for it. Therefore, I will sell it to you for $500 so that the $50 annual interest paid on the bond is equal to 10% of the amount you paid for the bond.

Similarly if I had purchased a bond that paid 10% interest and rates dropped to 5% then numerous people would want to buy it from me for $1,000 so they could get 10% rather than the current 5% on their $1,000 investment. These people would compete for the bond and bid its price up until it reached $2,000 (at which point the $100 per year interest being paid would be a 5% return on their $2,000 investment).

This is why bond prices fluctuate as interest rates fluctuate when they are resold or traded before maturity.

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