The main factors that impact the prices of fixed-income securities include interest rate changes, default or credit risk, and secondary market liquidity risk. Fixed-income securities are loans made by an investor to a government or corporate borrower. The issuer of the bond agrees to pay a fixed amount of interest on a regular schedule until the maturity date of the bond. At the maturity date, the borrower returns the principal amount to the investor.
The fixed amount of interest is known as the coupon rate, and the principal amount of the bond is known as the par or face value. There are several different type of fixed-income securities, including U.S. Treasuries, corporate bonds, high yield bonds, and tax-free municipal bonds.
Changes in Interest Rates
The main risk that can impact the price of bonds is a change in the prevailing interest rate. The price of a bond and interest rates are inversely related. As interest rates rise, the price of bonds falls. This is because investors can obtain bonds with a superior interest rate, which decreases the value of a bond that has already been issued.
On the flip side, current bond holders benefit from a drop in interest rates, as it makes their bonds more valuable with other investors seeking out higher yields of previously issued bonds. Bonds with longer maturities are subject to greater price movement upon interest rate changes since an interest rate change has a larger impact on the future value of the coupon.
Credit or Default Risk
The second main factor is credit or default risk. There is a risk that the issuer will go out of business and be unable to pay its interest rate and principal obligations. Issuers of high-yield bonds have more credit risk since there is likely to be a greater risk of default. To compensate investors for this higher risk, such bonds often pay higher interest rates.
Rating agencies provide credit ratings for the issuers of bonds and can help investors gauge the risk associated with certain corporate bonds.
Except for government debt, most bonds are traded over the counter (OTC) and therefore carry a liquidity risk. Unlike the stock market, where investors can easily exit a position, bond investors rely on the secondary market to trade bonds. Investors who need to exit a bond position – to access their invested principal – may have a limited secondary market to sell the bond.
Also, due to the thinner market for bonds, it can be difficult to get current pricing. Bonds vary so much in their maturities, yields and the credit rating of the issuer that centralized trading is difficult. However, FINRA introduced the Trade Reporting and Compliance Engine (TRACE) in 2002, which now requires all broker-dealers to report OTC bond trades, thereby increasing transparency in the bond market.