Question

What causes bond prices to fluctuate?  Although all bond prices fluctuate, which bond prices tend to fluctuate more? How does bond laddering and bond diversification help manage / optimize the risk/reward relationship?

Answer 1

What causes bond prices to fluctuate?  Although all bond prices fluctuate, which bond prices tend to fluctuate more?

Bond prices fluctuate with changing market sentiments and economic environments, but bond prices are affected in a much different way than stocks. Risks such as rising interest rates and economic stimulus policies have an effect on both stocks and bonds, but each reacts in an opposite way.

Here are three main things that drive changes in a corporate bond’s yield and so its price:

1. The closeness to the redemption date
2. The interest rate environment
3. The perceived risk of the bond defaulting

Factor 1. Closeness to redemption date

The closer a bond is to the date at which it will be redeemed for its nominal value by the issuing company, the likelier it is to be priced close to or at that value, since there’s otherwise a quick capital gain (or loss) to be made by holding. (See time value of money).

Factor 2. The interest rate environment

As interest rates rise and fall, the risk-free rate available from longer-term government bonds also rises and falls. This has consequences for corporate bond yields, since a government bond at a particular yield will always be more attractive than a corporate bond offering the same yield (see the next point). Therefore the yield and price of corporate bonds change as the risk-free rate changes.

Factor 3. The chances of the bond defaulting

If you can get a 4% yield from a government bond with a tiny risk of default, you wouldn’t accept 4% from a riskier and less liquid corporate bond. Investors will demand a greater return for the risks of holding the corporate bond in the form of a higher yield, which will reduce the corporate bond’s price.

This risk is called the ‘credit risk’, and it is usually determined by the market’s assessment of the issuing company’s fundamentals. If investors believe there’s a greater chance of a specific corporate bond defaulting than is reflected in its market price, they will demand greater returns for holding it – in other words a higher yield / lower price.

This difference between the risk-free rate and the yield on a corporate bond is known as the yield spread.

How much more yield investors demand from a basket of corporate bonds versus a basket of government bonds is typically influenced by economic and market cycles. At the time of writing, fear in the markets has led to a wide spread between government bonds and even highly-rated corporate bonds. In contrast, in a bull market spreads tend to narrow, as investors chase yield and so bid up prices for income-producing assets.

How does bond laddering and bond diversification help manage / optimize the risk/reward relationship?

"Laddering" refers to holding cash equivalent or income-yielding assets of different maturities in a portfolio, with the goal of creating predictable streams of cash flow. You can build a ladder using certificates of deposit, bonds--anything that has a fixed payment amount. You then hold these securities until they mature--picking up any income produced along the way--and get back your principal amount back at maturity.

There are two main reasons to use the ladder approach. First, by staggering the maturity dates you won't be locked into one particular bond for a long duration. A big problem with locking yourself into a bond for a long period of time is that you can't protect yourself from bullish and bearish bond markets. If you invested the full $50,000 in a single bond with a yield of 5% for a term of 10 years, you wouldn't be able to capitalize on increasing or decreasing interest rates.

For example, if interest rates hit a bottom five years—at maturity—after purchasing the bond, then your $50,000 would be stuck with a relatively low interest rate even if you wanted to buy another bond. By using a bond ladder, you smooth out the fluctuations in the market because you have a bond maturing every year or so.

The second reason for using a bond ladder is that it provides investors with the ability to adjust cash flows according to their financial situation. For instance, going back to the $50,000 investment, you can guarantee a monthly income based upon the coupon payments from the laddered bonds by picking ones with different coupon dates. This is more important for retired individuals because they depend on the cash flows from investments as a source of income. Even if you are not dependent on the income, you will still have access to relatively liquid money by having steadily maturing bonds. If you suddenly lose your job or unexpected expenses arise, then you will have a steady source of funds to use as needed.

Advantages:

• The periodic return of principal provides additional investing flexibility
• The proceeds received from principal and interest payments can be invested in additional bonds if interest rates are relatively high or in other securities if they are relatively low
• Your exposure to interest rate volatility is reduced because your bond portfolio is now spread across different coupons and maturities
• The success of the bond ladder strategy is contingent on the bonds supplying your cash flows not defaulting--and this is no minor risk. This is why you should build a bond ladder with stable, high-quality, noncallable bonds. (Callable bonds can be paid by the bond issuer before maturity.)