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Understanding Bonds

The price of bonds is directly related to the level of interest rates. If interest rates go down the price of bonds will go up. If interest rates rise, the price of bonds will go down. Note the significance of the term to maturity of the bond. As the maturity of a bond increases, its market value becomes more sensitive to changes in interest rates. The longer the term of the bond, the more profound the change in market value.

Bond price moves opposite of interest rates

For example if you had purchased a 6% 5 year strip bond at a price of $100 and the rates dropped 1% to 5%, the resulting change in price would be up 4.38% and the new price would be $104.38. If the rates went up by 1% then the price would go down to $95.84 which is a 4.16% drop in value. The impact of changing rates is more profound when the term of the bond is higher. Suppose you had purchased a 6% 20-year strip bond at a price of $30.66 and the rates went to 7%. The result would be that the price would drop to $25.26, which represents a 17.61% drop in price. If instead the rates went down 1%, the new price would be $37.24 or an increase of 21.49%.

The trading forum for bonds is essentially a network of telephone circuits between investment dealers and dealer brokers that are augmented by closed circuit video screens. This system brings dealers together to initiate transactions for their own accounts or to facilitate transactions for their clients. As transactions are made information is instantly available to all members of the investment dealer community as to what transactions have occurred, in what volume and at what prices.

Bond Funds

Buying a bond fund managed by a mutual fund company is another way to participate in the fixed income market. Generally, the cost (management expense ratio) for bond funds are much lower than those charged on equity mutual funds or for smaller bond transactions. Bond funds provide a low cost method of getting fixed income exposure without the potentially high costs brokers may charge to handle individual trade transactions.

A problem with bond funds is that while the average maturity of the holdings may fit with your objectives when purchased, the funds objectives may change, which in turn could lead to different maturity and credit quality exposure than you may want.

This problem is being addressed by some funds. While they do not set it out in the funds' prospectuses they adopt a management policy that is well documented and which undertakes to stick to specific ranges for such things as credit quality and average maturity duration.