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Bond Prices

There are two primary reasons why bond prices fluctuate, and why you might not get back the full amount of the principal you paid to buy a bond if you have to sell before the bond matures.

The first reason is that people change their expectations about the ability of the bond's issuer—the company, government or agency that borrowed the money—to meet its obligations to pay interest and/or repay the principal. The more worried they are, the less willing they will be to pay for the bond. The increased risk investors take when they buy low-rated bonds also explains why these bonds typically pay a higher rate of interest than bonds that are highly rated.

The second reason is changing interest rates. If interest rates go up, the price of existing bonds, including the ones you hold, goes down. But if interest rates go down, the price of existing bonds will go up.

Some examples of bond fluctuations

Suppose you spent $1,000 for a bond paying 5.75% interest, or $57.50 a year. That interest is fixed for the term of the loan.

If the interest rates go up to 6%, investors won't be interested in bonds on which they'll earn less than 6%. But they will be willing to pay less than the face value, or the $1,000 you spent for the bond you own. Specifically, they'll pay enough less—in this case $958.33—so that the $57.50 they receive as interest equals the going rate of 6%.

To find the current price of a bond with a fixed interest payment, use the following formula:

Bond Price X Fixed Interest Rate = Annual Interest

In our example:

$1,000 X 5.75% = $57.50

Now, if interest rates rise to 6%, the value of the bond which pays annual interest of $57.50 is:

Bond Price X 6.00% = $57.50

Bond Price = $57.50/0.06 = $958.33

If on the other hand, rates fall, let's say, to 5%, the following will happen

Bond Price X 5.00% = $57.50

Bond Price = $57.50/0.05 = $1,150.00

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