After a bout of stock market unrest, investors may be tempted to put their faith in securities that are deemed safe, such as bonds.

At first glance, bonds would seem to present less of a risk and offer more stability than other investment vehicles. But don't be fooled: they are also volatile, which is to say that their value fluctuates. It is indeed possible to lose money by investing in bonds. So remember, forewarned is forearmed.

Fluctuating Values

Unlike guaranteed deposits, term deposits and government savings bonds, the values of debt securities traded on the bond market fluctuate daily. This important difference explains why investing in bonds not only generate interest, but can also lead to capital losses.

The value of a bond depends mainly on three things: its coupon rate (annual interest rate stipulated in the bond's issue contract), maturity date and prevailing interest rates.

An example

Suppose you hold a Bombardier bond that matures in December 2026 with a coupon rate of 7.35%.

These two features of the bond will not change; in one year's time, the maturity date will still be December 2026 and the coupon rate still 7.35%. Assuming that Bombardier continues to be financially sound, you would receive $73.50 interest each year (based on a hypothetical investment of $1,000 x the coupon rate of 7.35%) until 2026, at which point your capital will come due.

The bond value, on the other hand, will change as a result of market rates:
 

• If rates increase to 8% for bonds of a similar term, your bond will lose value since its coupon rate is lower. If you decide to sell your bond before it matures, you will obtain less for it than the value of your initial investment and you would suffer a capital loss.
• On the other hand, if the interest rate fell to 6%, your bond, which continues to pay 7.35%, would increase in value. If you were to sell it, you would obtain more than your capital investment and earn a capital gain.
   

Interest Rate and Value: An Inverse Relationship

Changes in interest rates largely explain why the value of a bond portfolio fluctuates. Whereas the value of a GIC, term deposit or a government savings bond is stable, that of a bond is volatile, and varies daily on the bond market.

In light of this, a rise in interest rates translates as a drop in the value of bonds. The relationship between market rates and bond values is reversed.

Keep your portfolio diversified

The answer-as always-is to keep your portfolio diversified, in line with your investor profile and your objectives. Don't put all your eggs in one basket, and spread your assets among the various investment classes: money market securities, bonds, Canadian and international stocks.

Is your portfolio appropriately diversified? See for yourself by using our convenient on-line calculator.