BOND YIELDS, RATES AND PRICING
Many new investors are surprised to learn that a bond’s price fluctuates and changes on a daily basis, just like that of any other publicly-traded security.
Glad we’ve got bond quotes down pat. Now, it’s time for bond rates and pricing. We’ll cover what a yield is and how bond rates are calculated.
What is a bond yield?
When people talk about the yield of a bond, they are generally referring to the term yield-to-maturity (YTM). The yield-to-maturity is the average annual return you can expect to realize by holding the bond to maturity, or to the end of its life span.
So, imagine you have a bond with a face value of $100 and it pays a 5% coupon yearly for 5 years. That means you are paid $5 every year plus you get your $100 back at the end. If at the end of 5 years, the bond’s price is still $100 then your coupon rate (5%) and your YTM are the same (5%). After all, if you earn 5% yearly for years, then your average annual return is 5%.
Where YTM differs is that it takes into account the bond’s current price. So if that changes, if it deviates in any way from $100, then your YTM will change. It will no longer be 5%.
So bonds can definitely be risky. Companies collapse all the time. Even government bonds carry some, even if U.S. Treasuries are often touted as being “risk-free”. If you buy a U.S. Treasury bond and interest rates rise, the price of the bond falls and if you sell, you will LOSE money. That’s a risk you have to bear. Of course you could always get around that by holding the bond to maturity.
Hold on, we just glossed over the fact that when interest rates rise, the price of a bond falls.
Imagine again that you own a bond with a face value of $100 and it pays a 5% coupon yearly for 5 years. We’ll call you Neo. You’ve literally just bought it but then all of a sudden, there’s a liquidity crunch and all the interest rates out in the world (this is very simplified, but bear with us) rise to 8%.
Picture yourself as a buyer of bonds in this environment, where companies are strapped for cash and are willing to offer 8% to people with the money to lend to them. Now you come across your other self, Neo who’s trying to offload a bond. He offers you a bond with a 5% coupon yearly for 5 years.
Would you, a buyer of bonds, buy that bond?
Hell no. Everyone else is offering you 8%. Now because you bought the bond and the coupon rate was agreed upon, it’s not like you can change that. Instead you negotiate on the only thing you can: the price of the bond. Thus, you offer him the bond at a discount. That’s why when interest rates go up, prices go down.
What are bond rates?
Bond rates are really just bond yields. The terms are used synonymously – don’t get confused!
How are bond prices determined?
It’s all about pricing.
In order to understand the pricing of bonds, start by logging in to your favorite financial website. Bond prices do fluctuate, so the price you see quoted may change several times throughout the next business day. Usually, bonds are broken down into municipal and corporate bonds.
When you are buying a bond from a market and not directly from the treasury or company, you pay either a premium or a discount. Here, we see the market price is 103.66. This means that I can buy a bond with a face value of $1,000 for $1,003.66. This is considered a premium, and is set by the market. If the price had been less that $100, it would be considered a discount.
Just like stocks, the price of a bond is determined by a few factors, but really comes to down to two main things: bid and ask (or supply and demand). If more people want to buy the bond then sell it, the price goes up and there will be a premium. If there are more people who want to sell the bond than buy it, the price will go down and there will be a discount.
There’s a lot to know about bond rates and pricing and it can feel overwhelming – we know. If learning about bonds interests you, check out our Investing in Different Markets course!