C. David Petrucci Investing Article

May 2003 Issue --> Investing Article

Why Bond Prices Change

By: C. David Petrucci

Investors include fixed income securities, such as bonds,in their portfolio for a variety of reasons. Fixed incomesecurities, are generally considered more conservative investments than equitiesare. Therefore, you may expect less price volatility from the fixed incomeportion of your portfolio. Similar to most financial markets, there arecertain factors within the bond market that may cause the value of anindividual bond to differ from the price at which it was purchased. Thefactors that may alter the value (or price) of the bond include changes ininterest rates or in the credit quality of the issuer.

It is important to note that a change in interest rates oran issuer's credit quality will typically have little effect on thetotal return of a bond held to maturity (barring default). Thesefluctuations typically affect the return on bonds that are sold prior tomaturity.

Interest Rates

One major factor that affects bond prices is movements ininterest rates. An inverse relationship exists between a bond's price andits yield. As interest rates rise, bond prices typically fall to bringtheir yield in line with the higher yields available in the market. Forexample, let's assume the current interest rate in the market for a bondmaturing in five years is 6%. Therefore, new bonds being issued will mostlikely be issued at par ($1000) and have a 6% coupon (or $60 per year inincome from coupon payments). If prevailing interest rates rise to 7%, the 6%bond will be worth less because now an investor can pay par for a bondthat pays a higher rate of interest than the one the investorcurrently owns. Therefore, the 6% bond will most likely trade at a pricebelow par (at a discount).

Conversely, as interest rates fall, bond prices typicallyrise to bring the yield in line with the lower yields available in themarket. Consider the same bond in the previous example. Assume prevailinginterest rates fall to 5%, then the 6% bond will be worth more due to thehigher rate of interest earned by the bondholder. As a result, the bondwill most likely trade at a price above par (at a premium). Since bondprices fluctuate with the movement in interest rates, it is important tonote that the value of a bond sold prior to maturity may be higher orlower than the purchase price.

Credit Quality

The credit quality of an issuer can also play a role indetermining a bond's value. In general, credit quality is the ability ofthe issuer to make interest and principal payments on time and in full.If the credit quality of an issuer begins to deteriorate, the value ofthe bonds could decline. On the other hand, if the credit quality of anissuer begins to improve, the value of the bonds may increase. In addition,lower credit quality bonds (below investment grade or non-rated bonds)will usually have more price volatility than higher quality securities.

There is also a link between a bond's maturity date andprice. For changes in interest rates or credit quality, bonds with longermaturities fluctuate more in price than bonds with shortermaturities. As a result, an investor is usually compensated for this increasedprice variation with higher yields.

You will most likely see the value of the fixed incomesecurities in your investment portfolio vary from month-to-month. As interestrates change, the prices in the bond market are bound to fluctuate. Inaddition, the credit quality and maturity can also affect the value ofthe bond. It is important to consult a qualified financial professionalwhen evaluating the fixed income securities in your portfolio, in light ofyour investment objective.

C. David Petrucci, CFP(r) is a AssociateVice-President-Investments of Legg Mason Wood Walker, Inc., a diversified securitiesbrokerage and financial services firm that is a member of the New York StockExchange, Inc. and SIPC.

Direct: 301 663.8833
Toll Free: 800 634.0072
Fax: 301 663.4798
Email: cdpetrucci@leggmason.com
Visit my Web Site: www.davidpetrucci.com

Advice from David...
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