Bonds are debt instruments issued by governments and companies, with factors such as creditworthiness, term, and characteristics affecting their present value. Credit rating agencies assess issuers’ financial health, with high-risk bonds paying higher interest rates. Bond prices can fluctuate based on interest rate movements, call options, and conversion options.
Bonds are debt instruments that can be issued by both government entities and private companies. Several factors, including the creditworthiness of the issuer, the term of the bond, and the characteristics of the bond, have an impact on the present value of a bond. Bonds have terms ranging from six months to 30 years, with longer-term bonds typically paying the highest interest rates.
When bonds are issued, credit rating agencies review the bond issuer’s accounts and attempt to assess the financial health of the issuer. The agencies also review records related to the issuer’s past debt history. The bonds receive credit ratings based on the agency’s findings; Bonds with high credit ratings generally end up paying low yields, while high-risk bonds pay higher interest rates. The present value of a bond can change based on changes in the issuer’s credit rating. An improved credit rating may not affect a bond’s price, but deterioration in the issuer’s creditworthiness will typically cause the prices of outstanding bonds to fall.
In most cases, bondholders receive interest payments over the life of the bond and a return of the premium at maturity. Short-term bond prices tend to fluctuate very little, as bondholders can earn a return on the premium by holding a bond for a few months. In contrast, the prices of multi-year bonds can vary greatly over the term of the bonds as a result of interest rate movements. If the rates on newly issued bonds are higher than previously issued bonds, then the present value of a bond issued in the past will decrease. The value of such a bond will increase if interest rates on newly issued bonds begin to decline.
Some bonds include call options that allow the bond issuer to pay off the debt before maturity. In general, the issuer can only call for such bonds on particular dates during the bond’s term. As this date approaches, the present value of a bond increases or decreases, so that the current market price is approximately equal to its face value. Once the call date passes, the value of the bond can fluctuate again based on other factors, such as supply and demand.
Many corporate bonds have a conversion option that allows bondholders to convert these debt instruments into equity. Due to the conversion option, the present value of a bond will be affected by the market value of the company’s stock. If the stock price falls, the conversion option becomes less valuable and the value of the bonds falls. The opposite occurs when stock prices start to rise.
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