Bond prices, while typically less volatile than stock prices, can still fluctuate in the secondary market based on changes in the issuer's credit rating and movements in prevailing interest rates. The price of bonds in the secondary market tends to drop when interest rates rise. A mutual fund that invests primarily in bonds will experience a loss in the value of its investments when prevailing interest rates rise, and it will pass that loss on to its shareholders.
The Bond Market
A bond is an I.O.U. of sorts. When you buy a bond, you are loaning money to the issuer, which could be the federal government, a corporation or a municipality, in exchange for regular interest payments and the promise of the return of the face amount of the bond at a set future date. After the initial offering, many bonds trade in the secondary market, where their prices can fluctuate. If you hold your bond until it matures, you get the full face value back. If you sell your bond prior to maturity, you might get more or less than the face value.
Bond prices in the secondary market tend to move in the opposite direction of prevailing interest rates. This type of price movement has nothing to do with the quality of the bond or the issuer's payment history. It has to do with competition. You wouldn't pay $1,000 for a bond in the secondary market that pays 3 percent interest, when you could spend $1,000 for a newly issued bond that pays 4.5 percent interest. The market price of the 3 percent bond has to decline to give the buyer a comparable return on his investment.
Bond funds are mutual funds that invest primarily in bonds. They provide a one-stop shop where you can obtain a diversified portfolio of bonds without spending a fortune, and without the need to research the issuers' credit ratings. While bonds typically pay semi-annual interest, bond funds might pay monthly or quarterly dividends. There are a multitude of different kinds of bond funds with investment objectives ranging from generating interest from conservative, safe U.S. government -backed securities, to high-risk, high potential reward junk bond funds.
Interest Rate Risk
Since the market price of bonds tends to decline when prevailing interest rates rise, the bonds inside a bond fund will also decline during periods of rising interest rates. This decline in market value will be reflected in the fund's net asset value. How the bond fund's market price is affected over the long term depends on the fund's management. If management chooses to hold the bonds in its portfolio to maturity, it will not lose money on the bonds, but it will produce lower interest income. If the fund's management actively trades bonds to purchase new bonds with a higher interest rate, the fund will likely lose money on its investments, but it will produce a higher rate of interest.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.