The Mechanics of a Bond

It appears that some investors have a difficult time understanding how and why bond prices move. The answer is really pretty simple. Think of a child’s seesaw, with a bond’s price on one end and its yield on the other. The two ends always move in opposite directions. With the bond price at one end of the seesaw and its yield at the other, every movement down in price increases the yield.

This is exactly what happens in the real market. If an investor purchases a bond at a specific price, which is a specific yield, the investor is locked into that yield until the bond is called by the issuer or matures. If the bond is held to maturity then the investor receives par value which is $1000 per bond.

The one thing all investors can be certain about is that from the time a bond is purchased until it matures, interest will gyrate up and down and sometimes with violent moves. So, even though you may hold your bond until maturity; the price in the market adjusts to the latest interest moves. If rates rise and yields on new bonds with the same maturity as yours are higher, then the price of your bond declines in order to adjust to a higher interest rate environment. “If” you had to sell you would suffer a loss of principal. Remember the old seesaw; interest rates moved up so your bond price moved down.

And when interest decline the value of your bond increases in order to adjust to lower rates. Rates go up; prices go down. Rates decline; prices go up. It’s that simple!