What causes corporate bond prices to fluctuate?

There 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

Let’s consider each factor in turn.

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.

Credit risk is the main difference between investing in government and corporate bonds. With government bonds you can be extremely sure of receiving the interest you’re due and having your capital returned. But corporate bonds can and do default.

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.

Corporate bonds can be grouped according to how risky they are perceived to be, as we’ll see in the next part of this series.