How can the value of bonds fall?

You would think that a bond is a pretty safe investment – the issuer pays you interest over time and the principal back at maturity. Relatively few bonds actually default and you don't get your money back.

Yet, the value of a bond can go up and down for two reasons:

• Changes in market interest rates

If interest rates go up to, say, 5% when your bond is only paying 4% interest, the value of your bond will fall because investors who for $100 can buy a bond that pays 5% interest will pay less for your bond which only pays 4%.  The price will be the amount which gives them a 5% return on buying you and it will be less than $100.

The opposite applies when interest rates fall. Your bond will be more valuable in comparison to prevailing rates and its value will rise.

• Changes in the issuer’s creditworthiness

Bonds are also priced in relation to their likelihood of default. The NZ Government can borrow at low-interest rates because it cannot default whereas companies with lots of debt borrow at far higher rates because there is a chance that they may be able to repay their debts at maturity.  A borrower whose financial profile worsens will have to pay higher interest rates to borrow more and this will depress the prices of its existing debt. Conversely, a borrower whose profile improves will see its bond prices go up.