Corporations, financial institutions, governments, and quasi-government institutions issue bonds. Many factors, including market interest rates, influence bond prices.
Bonds serve as debt instruments that finance capital expenditures. When someone buys a corporate bond, they are lending their money to the issuer for a set period, typically longer than one year. Then, the issuer pays interest to the bond buyer.
Debt instruments have become an important asset class for investors. For example, high-yield corporate bonds pay higher interest rates than investment-grade bonds because they carry a higher default risk. Understanding the key factors that influence corporate prices helps investors manage them.
Market interest rates heavily influence bond prices and determine the discount rate. When market interest rates increase, the discount rate rises, causing the bond value to fall because the cash flows are discounted at a higher rate. On the other hand, the value of a bond rises when interest rates decline because the corresponding cash flows are subject to a lower discount rate.
The structure of a bond can influence its price. The two main types are floating-rate and fixed-coupon-rate bonds. Typically issued by financial institutions, governments, and corporations, a floating-rate bond or note has two to five maturity years. It’s less sensitive to interest rate fluctuations than fixed-coupon-rate bonds, which are debt instruments whose interest rate is level over its entire term.
Additionally, the “call” and “put” options can influence the bond price as they determine potential early redemption and maturity. The issuer can redeem a bond through a call option before its maturity date. On the other hand, a bondholder can demand payment before maturity through a put option.
Because of market risk, an investor should consider the time horizon when buying a bond. If an investor thinks they might need the money sooner, it's prudent to consider buying a bond with a shorter time horizon. However, all things held constant, generally longer-term bonds tend to carry a higher risk than shorter-term bonds. The longer someone holds a bond, the higher the odds they will expose themselves to inflation risks, market declines, and interest rate changes.
Inflation risk is another factor that can impact bond prices. Sometimes, inflation causes returns on investments to fall behind the inflation rate. Generally, when inflation is rising, bond prices tend to fall and vice versa. Rising inflation erodes the earned return on investment.
The risk of default or credit risk is an issuer-specific factor. It refers to factors that directly impact an institution’s ability to meet its obligations. The higher a company’s credit rating, the more likely it will meet its payment obligations. When a bond issuer’s rating goes up, the price of its bonds will rise, and the opposite is also true.
A changing credit rating affects a bond’s face value and results in a lower or higher yield. However, over time, a bond issuer's credit rating can change. Agencies like Fitch, Standard and Poor's, and Moody's regularly publish credit ratings that categorize credit risk. Corporate bond institutional investors often supplement the findings of these agencies with their own analysis.
