Interest rates, junk bonds and bond prices

There are some important facts about bonds to establish. First, this is effectively (as explained in the basics of bonds article) a transaction in which you lend money to a company or government, and get it paid back at a future date, and with a fixed interest rate.

Now, the actual price of the bond itself is not something that is fixed in the market, and indeed it does fluctuate. There is a clear link that it is important to understand that exists between interest rates and the prices of bonds. If one goes up, the other goes down and vice versa. So a fall in interest rates will lead to bond prices rising.

This makes intituive sense because if interest rates are lower elsewhere, then the rate of return on a bond becomes more attractive; but then if interest rates go up and you can get the equivalent return in a basic savings account without any risk for instance, then the attractive and thus the value of the bonds falls.

As for junk bonds, this simply refers to those bonds that are considered to be a very high risk of defaulting, or not being able to pay back the money. This will be a company that has been awarded a low investment rating. As a result of being much riskier, there is also much higher potential reward: they need to offer a much higher interest rate to attract people to buy them as otherwise you would simply always take a lower risk product from a company that has very little chance of defaulting than take the risk for the same reward elsewhere.

It is an irony of course that the very fact they may have to offer such a high interest rate may actively make the company suffer in its attempts to stay afloat and pay back the bonds! This often seems to be the way with money - those who need money most and take out loans as an individual from companies who are considered highest risk may have the highest interest rates to cover the risk of the company that is lending them the money.

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