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Overview

From the time a bond is originally issued until the day it matures, its price in the marketplace will fluctuate according to changes in market conditions or credit quality. The constant fluctuation in price is true of individual bonds-and true of the entire bond market-with every change in the level of interest rates typically having an immediate, and predictable, effect on the prices of bonds.

When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues.
 
When prevailing interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues.
 
Because of these fluctuations, you should be aware that the value of a bond will likely be higher or lower than its original face value if you sell it before it matures.
 

The Link Between Interest Rates and Maturity

Changes in interest rates don't affect all bonds equally. The longer it takes for a bond to mature, the greater the risk that prices will fluctuate along the way and that the fluctuations will be greater-and the more the investors will expect to be compensated for taking the extra risk. There is a direct link between maturity and yield. It can best be seen by drawing a line between the yields available on like securities of different maturities, from shortest to longest. Such a line is called a yield curve.

A yield curve could be drawn for any bond market but it is most commonly drawn for the Government market, which offers securities of every maturity, and where all issues bear the same top credit quality.
 
By watching the yield curve, you can gain a sense of where the market perceives interest rates to be headed-one of the important factors that could affect your bonds' prices.
 
A normal yield curve would show a fairly steep rise in yields between short- and intermediate-term issues and a less pronounced rise between intermediate- and long-term issues. That is as it should be, since the longer the investor's money is at risk, the more the investor should expect to earn.
 
If the yield curve is said to be "steep," it means the yields on short-term securities are relatively low when compared to long-term issues. This means you can obtain significantly increased bond income (yield) by buying a longer maturity than you can with a short one, and you may wish to modify your choice of bond accordingly. On the other hand, if the yield curve is "flat," it means the difference between short- and long-term rates is relatively small. This means that the reward for extending maturities is relatively small, and many investors will choose to stay in the short end of the maturity range. When yields on short-term issues are higher than those on longer-term issues, the yield curve is said to be "inverted." This suggests that investors expect interest rates to decline. An inverted yield curve is sometimes considered to be a harbinger of recession.
 

The Interest Rate-Inflation Connection

As an investor, you need to know how bond market prices are directly linked to economic cycles and concerns about inflation. You may have wondered why press reports say the bond market fell after the government released positive economic news about job growth or housing starts. As a general rule, the bond market, and the overall economy, benefit from steady, sustainable growth rates. Moderate economic growth also benefits the financial strength of the government, municipal and corporate issuers whose bonds you may hold, making them a stronger credit.

But steep rises in economic growth can lead to inflation, which raises the costs of goods and services for everyone, leads to higher interest rates and erodes a bond's value. Ultimately, persistent and rapid economic growth will lead to rising interest rates, either through actions taken by the Federal Reserve to slow the expansion, or through market forces acting in anticipation of interest rate moves. Since rising interest rates push bond prices down, the bond market tends to react negatively to reports about strong economic growth.
 

Assessing Risk

Virtually all investments have some degree of risk. When investing in bonds, it's important to remember that an investment's return is linked to its risk. The higher the return, the higher the risk. Conversely, relatively safe investments offer relatively lower returns.