A normal, or “straight,” bond periodically pays interest and then returns the original investment on the maturity date. A straight bond’s coupon, or interest, payments are fixed. At issuance, the bond is priced so its yield -- the annual income divided by the principal amount -- is about the same as bonds with similar characteristics. A bond fund is a pooled investment in bonds, often classified by its industry sector. The yield on a bond fund changes to match current interest rates. If interest rates rise, so must the bond fund yield.
Let’s assume a typical straight bond has a par value of $1,000, which is the principal amount of the bond that is repaid on the maturity date. An investor buys the bond because the yield makes it an attractive source of income. The yield is the required return. If the bond has an annual return that's less than the required yield, it must be priced at a discount -- less than $1,000. The opposite is true of high-return bonds. Thus, the bond price is adjusted to make the yield competitive with other, similar bonds and with interest rates in general.
Bond Modified Duration
Bonds are traded throughout their lifetimes. The current price of a bond must be continually adjusted to reflect current interest rates, since the bond’s coupon is fixed. If interest rates rise, our existing bond’s price will decline, and vice versa. The sensitivity of the inverse relationship between bond prices and interest rates is measured by a number called the modified duration, or the percentage rate of change of price with respect to interest rates. A lower duration means that a bond’s price will experience a relatively smaller change in response to changing interest rates than will a bond with a larger duration.
Bond Interest Rate Risk
The two main forms of bond risk are default risk and interest rate risk. The latter risk is that interest rates will rise, lowering your bond’s price. Your actual interest rate risk is based on the bond’s duration. If you want to lower your interest rate risk, select a bond with a smaller duration than its competitors. Factors that lower duration are higher coupon rates and shorter maturities. All things being equal, if interest rates rise, bonds with smaller durations will lose less value than bonds with larger durations.
Everything that's true of individual bonds is true of bond funds. The modified duration of a bond fund is the weighted average of the individual bond durations. When interest rates rise, the value of a bond fund will decline. When interest rates fall, the bond fund gains value. These changing valuations of a bond fund are necessary to keep the bond fund’s yield in line with current interest rates. That means bond prices must adjust. For a bond fund, that means adjustment to its net asset value to keep its yield at current interest rate levels.
Video of the Day
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