The Layman's Explanation Of: Bond Price Fluctuation Affecting Bond Mutual Fund

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Let’s assume I wish borrow a lump sum of money from you, which I will repay two years later. In return, you think you need 10 percent return for the trouble of lending me the money. On top of that, you require a bonus payment of $ 1,000 at the end of each year for this deal to go through. We put this in a contract.

Say, two weeks from now, I deduced that I need $ 10,000. I also realized people are willing to lend me $ 10,000 for two years and contend with a 8 percent return. However, I want to honour the contract we have put down in black and white. So I approached you and told you this fact. Apparently, you too, have discovered that the ongoing market rate is 8 percent. You now agree to accept 8 percent return of investment (ROI) on your principal, inclusive of the two bonus payments. In order to avoid the hassle of altering any of the 3 terms in the contract earlier, the only factors that we can change here is the amount of principal you lend me.

You will now lend me $ 10,356, a little extra than $ 10,000 which I require. (Note that if required ROI were 10 percent as previously, and everything being equal, you would have lend me $ 10,000)

This explains why when market is down (characterized by lower interest rate and plunging stock market), your friendly neighbourhood UTC (Unit Trust Consultant) will ask you to buy or switch to Fixed Income Fund. Most fixed income funds essentially consist of government and corporate bonds which goes up in value during economic recession. Generally, when the bond portfolio in fixed income fund rises in value, the Net Asset Value (NAV) of the fund goes up.

Another politically correct way to understand this is as follows. Assume that the inflation rate is at 3 percent last year. You bought a 6 percent coupon bond with $ 10,000 which repays you in two years. So your real net anual return was 3 percent. This year, inflation rate goes up to 6 percent. No one wants to buy the same bond you have now for $ 10,000 because the real net return is 0 percent. To attract buyers, the bond issuer needs to sell the bond at a discount. This means, new buyers still get 6 percent coupon payment on $ 10,000, but they only pay upfront, say, $ 9,500. They will be repaid $ 10,000 two years from now.

Conversely, if inflation rate goes down to 1 percent this year, the bond you bought last year becomes even more irresistible now due to a net return of 5 percent per annum. Everyone now wants a piece of the action – new buyers will rush to buy this bond. Based on the law of supply and demand, this drives the bond price up. Hence, the bond is trading at a premium, say, at $ 10,500. New buyers will still get 6 percent coupon payment on $ 10,000, but now they pay upfront $ 10,000. They will be repaid $ 10,000 two years from now.

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