What Determines Bond Prices?

Bonds sold by corporations and governments to borrow money are purchased by investors seeking current income. Each bond pays a fixed sum annually, called the coupon rate. At maturity the bond must be redeemed for the par value stated on the bond. Until maturity, the prices of bonds usually differ from the face values. The astute investors learn what influences bond prices and can use that knowledge to guide investment decisions.

To understand the influences on bond prices, you should know how bond prices are determined. Investors want as high a yield as possible for the money they invest. When bond prices are low, investors must pay less for a bond, and so get a better yield. That increases demand and so tends to push prices up. By contrast, high bond prices mean lower yields. Investor demand falls off, and bond prices are likely to fall as well until the yield is high enough to attract investors.

When prevailing interest rates change, bond prices tend to move in response. This sensitivity to interest rates is the single greatest influence on bond prices. Suppose the average interest rate available to investors goes up. A bond’s current yield is then a less attractive investment. Investor demand falls off and the bond price declines until the yield improves enough to again be competitive with prevailing rates.

The reverse occurs if interest rates go down. Then, existing bond yields are relatively more attractive. Investor demand for the bonds grows and pushes bond prices up.

Investors must take the credit risk of the issuing entity into consideration. Essentially, credit risk is the likelihood that the issuing entity will or will not be able to repay the bond at maturity. This particularly applies to corporate bonds, because corporations have more risk than most governments.

Bonds are evaluated and rated by several services, including Moody’s and Standard & Poor’s. A top rating (AAA) means the bond carries the least credit risk. If a company’s rating is downgraded, the bonds will normally fall in price because investors won’t pay as much for them.

There is less certainty about what conditions will be like years from now than there is about the immediate future. In the financial world, uncertainty translates into risk. Consequently, bonds with long maturities have somewhat more risk and tend to be priced less (or have higher yields). As these bonds eventually start to approach their maturity date, their prices start to get close to the par value. That’s because investors know they will soon be getting their money, and little credit risk remains.

Not all bonds are the same. Many, especially corporate bonds, have special features. One type is the “callable” bond. The company that issued the bond retains the right to redeem it early. This can become advantageous to the company if interest rates fall. A company can call its outstanding bonds, pay them off, and then issue new bonds with lower coupon rates. The investors who purchased the bonds lose out on the high yields they were receiving. Because callable bonds can work to the disadvantage of investors, they typically command lower prices or have higher yields, to offset the increased risk investors take when buying them.