How Bonds Work

Nov 28, 2011 by

Bonds are a head-scratcher for many. Headlines like “Bond Prices Fall as Fed Gets Aggressive on Inflation” and “Bond Vigilantes Drive Up Rates on Italy’s Sovereign Debt” mean little to those outside of high finance. But grasping just a few basic principles will help you better understand why bond prices change.

Corporate BondWhat Is a Bond?

A bond is similar to a loan. A corporation or government borrows money from anyone willing to purchase a bond through a “bond issue.” To entice people to buy its bonds, the borrower pays interest. Generally, bonds are issued in $1,000 chunks. So if Corp A wants to borrow $100 million to invest in new equipment, it might issue one hundred thousand $1,000 bonds.

Why Would Anyone Buy a Bond?

Investors buy bonds to 1) earn interest, and 2) possibly reap a capital gain by selling the bond if its value increases (more on this below). Corp A’s $1,000 bond offering will specify an interest rate, also called the “coupon rate.” Let’s say it’s 5%, paid semi-annually. Twice a year Corp A will send a check for $25 (5% interest annually on $1,000 is $50, paid in two equal installments) to every owner of one of its $1,000 bonds. Corp A will continue sending interest checks until the bond issue “matures,” which may be years or decades in the future. When the issue matures, Corp A will repay the original $1,000 loaned (the “principal”) to each owner of its bonds.

Why Do Bond Prices Change?

After a bond is issued, it trades in the “secondary market,” just like a stock. Millions of bonds are bought and sold among traders and investors every day.

Many factors affect the value, or price, of a particular bond, but the two big influences are 1) future inflation expectations (as reflected in general interest rates) and 2) the risk of Corp A “defaulting”—not meeting its obligation to make each year the $50 interest payment and, eventually, repaying the $1,000 bond principal.

Let’s say it’s been five years since Corp A issued its bond with a 5% interest rate, and since then the general level of interest rates has risen so that, today, I could buy a comparable $1,000 U.S. Government bond that pays 4.9% interest. Why would I pay $1,000 for a Corp A bond paying 5% interest—and take on the risk that Corp A may default—when I can make almost as much interest on a “risk-free” (we hope) U.S. Government bond? In this scenario, no one would pay $1,000 for Corp A’s bond—it’s overpriced at $1,000. So the price, or value, of that bond in the secondary market must fall to entice anyone to buy it.

How Are Bond Market Values Set?

The price of Corp A’s bond will fall until investors, as a group, think the $50 per year in interest Corp A is paying to its bond owners compensates them fairly for the risk they take by owning the bond. For example: If investors think, given current inflation expectations and the perception of Corp A’s financial condition, that Corp A’s bond should pay 7.5% interest, then they’ll pay only $667 for the bond issued at $1,000. Why? Because the $50 per year in interest Corp A is paying to its bondholders works out to a 7.5% interest rate if one pays $667 for the bond.

$50 / $667 = 7.5% annual interest

What about the individual who paid $1,000 for the bond when it was issued? She’s out, or has a capital loss of, $333 if she sells her bond at $667. Her alternative is to hold the bond until it matures, possibly many years in the future, when she’d be repaid the original $1,000 she loaned Corp A, and collect all the interest payments along the way. Or her bond could rise in value, reducing her loss if she waits to sell. Of course her bond’s value could also decline even further.

What if Corp A Goes Bankrupt?

If Corp A enters bankruptcy, owners of its bonds may get back a fraction of the $1,000 they lent to Corp A, or they could get nothing. A bankruptcy court and legions of attorneys sort it all out.

Summary

In sum, bond values on the secondary market change based mainly on the collective perception of investors about future inflation and the likelihood that the bond issuer will continue to make interest payments and repay bondholders when the bond matures. The higher inflation expectations or the risk of default as perceived by investors, the lower a bond’s price will fall, and the higher its yield will become. That is, unless the issuer does default; then the yield becomes zero. To illustrate, as of this writing:

  • A U.S. Government 10-year bond yields 1.96% (very low yield, and so very low perceived risk of default, despite the credit downgrade)
  • A Greek Government 10-year bond yields about 29% (extremely high yield and perceived likelihood of default)
  • The Vanguard High-Yield (aka Junk) Bond mutual fund yields about 6.5% (relatively high yield and perceived likelihood of defaults).

Should You Invest in Bonds?

Like anything else, not unless you, or your financial planner, know what you’re doing. You should thoroughly understand the bond market and why bond prices change before investing in bond.

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