Bonds are marketable securities that trade on the secondary markets for the specific bond types. Municipal, corporate, government and mortgage backed securities all trade in their markets, with bond prices set by the expectations of buyers and sellers in those markets. Selling bonds is a way for the bond issuers to borrow money.
A change in market interest rates will have the most direct effect to change a bond's market price. Bonds pay a fixed rate of interest called the coupon rate. For example, a bond with a $10,000 face amount and a 6-percent coupon rate will pay an investor $600 in interest every year plus the $10,000 face amount when the bond matures. If the market rate for similar bonds differs, the bond's market price will adjust to bring the rate in line with market rates. Using the example, if rates are higher than 6 percent, the market price of the bond will be lower than $10,000. If rates are lower than 6 percent, the bond will trade at a higher price to provide a market yield to an investor. Rising rates cause bond prices to fall and falling rates cause bond prices to increase.
Issuer Credit Rating
Bond issuers, governments and corporations receive credit ratings from the rating agencies, Moody's, Standard & Poors and Fitch Ratings. The ratings use letter grades, starting with AAA as the highest, stepping down through AA, A, BBB and on through single C or D, depending on the agency. As a bond issuer's credit rating decreases, it must pay a higher rate of interest to sell bonds and borrow money. Bonds with similar credit ratings will have similar market yields and the prices of similar rated bonds will move together. Bonds at different rating levels may change prices while other levels do not. For example, high-yield bonds (those ratings below BBB) are more sensitive to the economy and the prices will change with an improving or slowing economy. A ratings change for a specific issuer will change the bond prices of the issuer. An improved credit rating will result in higher bond prices and a reduced rating will cause the issuer's bonds to fall in value.
Prepayment or Call Features
Specific bond terms may cause a bond's price to react unexpectedly to changing interest rates. Bonds that the issuer can then call in early will not have as much of a price increase in relation to falling interest rates. If rates decline, the issuer can call the bonds and issue more at the lower rate. Bonds that have an indefinite payback schedule like mortgage backed securities--MBS--will be priced differently for changing interest rates. Rising rates will slow the prepayment of mortgages backing a MBS, increasing the expected maturity of the bond and the market will price the bond differently. Falling rates will cause homeowners to refinance their mortgages, shortening the maturity of a MBS and reducing the possible price gain from falling rates.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.