If considering investing in bonds or a bond-related investment such as bonds funds or bond ETFs, then an understanding of how interest rates affect the price and value of a bond to the investor is essential.
Fixed Income Securities: The Value of a Bond Held to Maturity
If a bond is purchased at the point of issue and held to maturity, then the value of the bond to the investor is simply the par value of the bond issued, plus the sum of the coupon interest payments to be made over the life time of the bond.
As fixed income securities, the coupon payments of a bond will not fluctuate with underlying moves in the base rate of interest as issued by central banks. However, movements in underlying interest rates will see the relative value of the investment fluctuate.
In general, a fall in interest rates will mean that an investment in bonds has been a wise one as the value of alternative investment options falls. On the other hand, should interest rates rise, the relative value of investing in bonds falls, as the investor may have been able to gain a better return in an alternative security.
Investment in Bonds: The Value of Bonds in the Secondary Market
In the field of bond investment, one consideration is that not all bond investors will wish to hold a bond until maturity. As such, investors need to consider that capital gains and losses may be made due to fluctuations in the price of a bond in the secondary market.
In essence, the impact of interest rates upon the value of a bond in the secondary market is the same as that of the investor who holds the bond to maturity. However, the difference is that the bond investor who holds the bond to maturity will only see the value of their investment fluctuate on the conceptual level. Those who wish to actually buy and sell bonds within the secondary market will stand to crystallise such profits and losses in the form of capital gains and losses.
When interest rates rise, the relative value of a fixed income security such as a bond falls. In effect this will see the market value of a bond fall in the secondary market and the investor crystallising a capital loss. Conversely, where interest rates fall the relative value of a fixed income security rises and the corresponding rise in the value of the security should be reflected in the secondary market. Here the bond investor should make a profit derived from capital gains.
In summary, there is a distinct relationship between the value of a bond to an investor and the underlying interest rates issued by a central bank. In essence, rising interest rates will see bonds becoming a less attractive option for bond investors whilst an expectation of a fall in interest rates will see bonds becoming a more attractive option.
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Frank Smith - Frank Smith currently works as an full time industry analyst for a well known construction company in Lincolnshire. In his spare time, ...
