What Happens When Bonds Drop?
Original post by Slav Fedorov of Demand Media
Bonds in the secondary market can trade for more or less than their face value -- the contractual amount to be repaid at maturity. Bond prices may drop for several reasons including rising interest rates, inflation, credit rating downgrades or an issuer's financial problems. When bonds drop, bond yields rise, while investor portfolios decline in value.
Rising Bond Yields
Bond interest is expressed as a percentage of par, or face value, at issuance. However, it is fixed for the life of the bond in dollars until maturity. For example: A 5 percent 10-year XYZ bond will pay $50 annually for each $1,000 of face value. Bond yields are calculated by dividing the amount of interest by the current bond price. If the XYZ bond drops to $900, its current yield would increase to 5.56 percent ($50 ÷ $900). Current bond holders would continue to collect the $50 in interest but lose 10 percent in bond principal. Investors who buy the bond at $900 will lock in the higher yield.
At maturity, all investors will collect the bond's full face value -- $1,000, regardless of how much they paid for the bond. As long as an investor holds a bond to maturity, a drop in price is a temporary paper loss, but if an investor sells a bond prior to maturity for less than its face value, he will have an actual loss. Bond credit rating downgrades commonly cause individual bond price declines, but most lower-rated bonds still repay interest and principal in full. Some bonds do default. A series of ratings downgrades (and corresponding bond price drops) may indicate serious financial trouble that could result in a default and a total or substantial loss of principal to the bondholders.
Bond Fund Losses
Bond funds do not have maturities because they constantly buy and sell bonds in their portfolios. When bond fund investors sell their shares at a loss, the bond fund must sell bonds from its portfolio to meet the redemptions. If the bond fund no longer owns a bond, it cannot get the bond's full face value back at maturity, so bond fund losses become permanent. When a bond fund sells bonds at a loss, its own share price drops, which means that investors who are in the fund lose money.
A bond price drop could cause investor panic selling. When some bond investors see their bond balances shrink, they begin to fear even bigger losses down the road and sell to preserve what's left. Their selling causes further price drops, which scares more investors into selling.
- "PassTrak Series 7: General Securities Representative License Exam"; Dearborn Financial Services; 2003
- SIFMA: Rising Rates and Your Investments
About the Author
Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.