Measuring Bond Volatility

Bond volatility is a term used to describe how much the value of a bond fluctuates over time. The less volatile the bond, the less risky the investment. More volatile bonds present more risk, but they also can present the higher reward possibility. Tracking volatility can give you insight into the potential risks and rewards of purchasing a bond.

Bond Spread

One way to measure a bond's volatility is to track its spread against another bond. Basically, you will need to compare the bond's performance over time to a relatively stable bond. The most stable bonds are US Government Bonds. Start with a federal bond and track interest rate over a time period of 1 to 5 years. Track the interest rate of the bond you are measuring over the same time period. The difference between the interest rates is called the "spread." If this spread is consistent over time, then you will know the bond has low volatility. If this spread jumps around a lot, then your bond is more volatile. It is important to test the spread with a very stable bond for this measurement to work.

Bond Duration

Duration is another way to measure bond volatility. Duration is a measure of how much the price of a bond changes when compared to its interest rate. Bond price will change from time to time as the issuing organization evaluates the value of the bond on the market. If you buy a bond at one price and then the price decreases, you may think you are out of luck. However, if the interest rate also decreases, your bond will hold its value because the duration, meaning the time it will take for the bond to pay back its actual value, remains constant. Tracking duration is a good measure of the volatility of the bond because it accounts for both price and interest rate.

Purchasing Volatile Bonds

Purchasing volatile bonds is not an all-together bad thing. Volatile bonds fluctuate in both directions. This means you could potentially buy at a low price and sell at a high price, which is the investor's dream scenario. When you purchase volatile bonds, though, you are accepting the possibility the bond may decrease in value and remain at a low value for a very long time. There is no guarantee a bond will come back up. Investors with a larger appetite for risk will potentially purchase more volatile bonds due to these factors.

Purchasing Low Volatility Bonds

Investors with a low appetite for risk will be happier with less volatile bonds. Though these bonds may see slight drops on a term-by-term basis, they will generally increase steadily over the time it takes them to mature. The only real risk with a very stable bond, like a municipal bond, is the possibility the municipality may go bankrupt and be unable to repay. With federal bonds, even this risk is eliminated. You should note that eliminating risk generally means accepting a much smaller interest rate. Your money may not grow as much as it could with a more volatile bond.

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