Where Did My Money Go? How Your Bonds Are Priced in Layman's Terms

Due to the extreme amount of movement in the market and increasing investor fears over losses the ability of financial institutions, properly valuing the bonds held in your investment account has become more difficult. Before we talk about the process of assigning a price to a particular bond, let's give it a cursory overview of the actual type of investment.

A bond can be considered a loan that you are giving to a company or government that needs funding for a particular length of time. During this length of time that company or government agrees to pay a specified amount of interest. In exchange for these funds, you receive a note that details the interest rate and date the funds are to be repaid. This repayment date is commonly referred to as the maturity date for a bond. It's common for the interest on a bond to be paid every six months, or semi-annually.

When looking at the statement provided by your investment services company you may notice that the value of the bonds you have purchased can vary from period to period. This fluctuation is caused by a number of different factors. Most brokerage firms use pricing services that create a customized price for bonds based upon a complex (and usually proprietary) computer formula. These formulas take into account factors such as the maturity date, interest rate, and credit worthiness of the borrowing entity. The only way to get the true price for a bond is to sell it on the open market.

Without starting a discussion on the types of institutions that are required to operate the bond market, is important to note that current market conditions are not favorable for consistent bond pricing. This means that if an institution such as AIG attempts to liquidate a portion of its assets, the prices of several bonds that it holds can fluctuate wildly. This price fluctuation can be affected by factors such as the availability of monoline insurers, or companies that provide insurance to bondholders.

When you attempt to sell a bond, it helps to get a number of bids from other investors or institutions that may be willing to buy it. These figures can help you understand what you're bond is worth at that moment in time. The number of institutions available to buy bonds that may be undervalued has declined severely due to problems in the market. In the long run, it may be better to simply close your eyes and hold onto the bonds you already have.

References:

http://asc.state.al.us/InvestorED/Acctstatement.37367-68586.pdf