Factors That Affect Prices of Fixed Income Securities

As an integral part of a well-balanced and diversified portfolio, fixed income securities afford opportunities for predictable cash flows to match investors individual needs, provide capital preservation and may offset the volatility of the stock market. However, all investments have some degree of risk. In general, the higher the return potential, the higher the risk. Safer investments usually offer relatively lower returns.

While the interest payment or coupon on most bonds is fixed and the principal amount, known as par value, is returned to the investor upon maturity, the market price of a bond during its life varies as market conditions change. Consequently, if a bond is sold prior to maturity, the proceeds may be more or less than the original purchase price or the quoted yield. If a bond is held to maturity, an investor can expect to receive the return or yield at which the bond was initially purchased, subject to credit worthiness of the issuer.

There are a number of variables to consider when investing in bonds as they may affect the value of the investment. These variables include changes in interest rates, income payments, bond maturity, redemption features, credit quality, priority in the capital structure, price, yield, tax status and other provisions that are covered in the offering documents.

In general, investors demand higher yields to compensate for higher risks. Discussed below are some of the most common risks associated with fixed income securities.

Interest Rate Risk

The market value of the securities will be inversely affected by movements in interest rates. When rates rise, market prices of existing debt securities fall as these securities become less attractive to investors when compared to higher coupon new issues. As prices decline, bonds become cheaper so the overall return, when taking into account the discount, can compete with newly issued bonds at higher yields. When interest rates fall, market prices on existing fixed income securities tend to rise because these bonds become more attractive when compared to the newly issued bonds priced at lower rates.

Price Risk

Investors who need access to their principal prior to maturity have to rely on the secondary market to sell their securities. The price received may be more or less than the original purchase price and may depend, in general, on the level of interest rates, time to term, credit quality of the issuer and liquidity. Among other reasons, prices may also be affected by current market conditions, or by the size of the trade (prices may be different for 10 bonds versus 1,000 bonds), etc. It is important to note that selling a security prior to maturity may affect actual yield received, which may be different than the yield at which the bond was originally purchased. This is because the initially quoted yield assumed holding the bond to term.

As mentioned above, there is an inverse relationship between interest rates and bond prices. Therefore, when interest rates decline, bond prices increase, and when interest rates increase, bond prices decline. Generally, longer maturity bonds will be more sensitive to interest rate changes. Dollar for dollar, a long-term bond should go up or down in value more than a short-term bond for the same change in yield.

Liquidity Risk

Liquidity risk is the risk that an investor will be unable to sell securities due to a lack of demand from potential buyers, sell them at a substantial loss and/or incur substantial transaction costs in the sale process. Broker/dealers, although not obligated to do so, may provide secondary markets.

Reinvestment Risk

Downward trends in interest rates also create reinvestment risk, or the risk that the income and/or principal repayments will have to be invested at lower rates. Reinvestment risk is an important consideration for investors in callable securities. Some bonds may be issued with a call feature that allows the issuer to call, or repay, bonds prior to maturity. This generally happens if the market rates fall low enough for the issuer to save money by repaying existing higher coupon bonds and issuing new ones at lower rates. Investors will stop receiving the coupon payments if the bonds are called. Generally, callable fixed income securities will not appreciate in value as much as comparable non-callable securities.

Similar to call risk, prepayment risk is the risk that the issuer may repay bonds prior to maturity. This type of risk is generally associated with mortgage-backed securities. Homeowners tend to prepay their mortgages at times that are advantageous to their needs, which may be in conflict with the holders of the mortgage-backed securities. If the bonds are repaid early, investors face the risk of reinvesting at lower rates.

Fixed income investors often focus on the real rate of return, or the actual return minus the rate of inflation. Rising inflation has a negative impact on real rates of return because inflation reduces the purchasing power of the investment income and principal.

The safety of the fixed income investors principal depends on the issuers credit quality and ability to meet its financial obligations, such as payment of coupon and repayment of principal at maturity. Rating agencies assign ratings based on their analysis of the issuers financial condition, economic and debt characteristics, and specific revenue sources securing the bond. Issuers with lower credit ratings usually have to offer investors higher yields to compensate for additional credit risk. A change in either the issuers credit rating or the markets perception of the issuers business prospects will affect the value of its outstanding securities. Ratings are not a recommendation to buy, sell or hold and may be subject to review, revision, suspension or reduction, or may be withdrawn at any time. If a bond is insured, attention should be given to the credit worthiness of the underlying issuer or obligor on the bond as the insurance feature may not represent additional value in the marketplace or may not contribute to the safety of principal and interest payments.