How Do Bonds Work?

The following post was originally published on Wealthminder

When I talk to individual investors, I often find they have a much better understanding of what stocks are and how they work than they do of bonds.  To help with that, we’ve developed a three part series on bonds.  Bonds have their own unique vocabulary and there are a lot of detailed nuances one could learn about, but for today, we’ll stick to the basics.

What is a Bond?

A bond is basically just a loan made to a corporation or government.  The lender and the borrower form an agreement under which the lender will receive periodic interest payments (usually twice a year) and ultimately will get back the amount lent (theprincipal).  The term for the interest rate paid annually is called the coupon rate.  The duration of the agreement, known as the maturity, can vary from days to decades.

Pricing

Pricing is the hardest thing to understand about bonds.  Bonds are priced with respect to something call par, which is equal to 100, and like stocks, the price of a bond fluctuates in the marketplace.  For example, if your bond appreciates by 5% from par, your bond’s price would be 105.

However, to make matters confusing, unlike stocks where a share is worth 1 * the stock’s price, bonds are usually worth 1 * the bond’s price * 10.  In other words, bonds are typically issued in $1,000 chunks, but are priced with respect to 100. Strange and confusing, but true.  Let’s look at an example.  Chevron has a stock price of 119. If I want to buy one share, it would cost me $119.  However, if a Chevron bond were quoted at 119, one bond would cost $1,190.

Another big difference between stocks and bonds is how they trade.  Unlike stocks, bonds do not trade on public exchanges.  Instead, they trade through a network of independent dealers.  Different dealers will have access to different inventory and will charge different mark-ups (like commissions for stocks).  Bonds also trade much less frequently.  The result is the quotes you get on a bond through different brokerages will vary (perhaps by a lot), whereas you will get the exact same quote for a stock through different brokers.  One consequence of this is it is much harder as an individual investor to get something close to the true current market price for a bond.

So, what affects the price of a bond?  The most common things are changes in credit risk and interest rates.  Changes in credit risk occur when borrowers believe there is a greater (or lesser) chance of default (a fancy word for not getting paid).  For example, Blackberry phones used to be incredibly popular.  Unfortunately, the company has fallen on hard times.  If I owned a Blackberry bond and wanted to sell it, I would need to discount my price to reflect the greater risk of non-payment.

Probably the thing that confuses investors most about bonds is the relationship between interest rates and bond prices.  The technical term is they are inversely correlated.  What does that mean?  It means that if overall interest rates go up, then the price of existing bonds will go down, and if interest rates overall decline, prices for existing bonds will go up.  Why?  Let’s use an example.

Say I own a 10 year treasury bond that pays me 2.75% per year.  Now, let’s assume interest rates quickly spike to 3.75% right after I buy the bond.  Next, say my friend Joe decides he wants to buy a 10 year treasury bond.  He can either buy my bond or a newly issued bond at 3.75%.  Since my bond only pays him 2.75%, if he had to pay full price for the bond, he would be silly not to buy the new 3.75% bond.  So, if I want to sell my bond to him, I will have to do it at a discounted price.

The math for how to do this is a little complicated, but I’ve included a table below that gives you a pretty good idea of how changes in interest rates will impact the prices of your bonds.  As you can see, the longer the duration of the bond, the greater the impact on the price.  This is because the value of a dollar the borrower gives you in the future is worth less than the value of a dollar they give you today.  You can also see that bonds with a higher initial coupon are impacted less by changes in interest rates.

4% Coupon Bond
Years to Maturity Rates Rise 1% Rates Fall 1% Rates Rise 2% Rates Fall 2%
1 -1.0% 1.0% -1.9% 2.0%
5 -4.4% 4.6% -8.5% 9.5%
10 -7.8% 8.6% -14.9% 18.0%
20 -12.6% 15.0% -23.1% 32.0%
30 -15.5% 19.7% -27.7% 45.0%

 

6% Coupon Bond
Years to Maturity Rates Rise 1% Rates Fall 1% Rates Rise 2% Rates Fall 2%
1 -0.9% 0.9% -1.8% 1.9%
5 -4.1% 4.3% -8.1% 8.9%
10 -7.1% 7.7% -13.5% 16.3%
20 -10.6% 12.5% -19.7% 27.3%
30 -12.4% 15.4% -22.6% 34.7%

 

Dates

There are several key dates associated with a bond.  The primary ones are the issue date, maturity date, call date, and payment dates.

Issue Date

This is the date the bond was issued at par.  When combined with the maturity date, you can easily calculate the initial duration of the bond.   For example, if a bond was issued on 10/15/2003 and matures on 10/15/2023, you know it is 20 year bond.

Maturity Date

This is the date the borrower returns the principal to the lender.

Call Date

The call date is a date which precedes the maturity date and gives the borrower the right to return the principal to the lender before the maturity date.  Not all bonds are callable and there are lots of nuances around the exact terms under which a bond can be called, but the most common case is that the borrower can return your original principal to you at any point between the call date and the maturity date.

Payment Dates

These are the dates when you will receive your interest payments from the borrower.  The most common arrangement is for the payment dates to be 6 months apart and be tied to original issue date.

Yield

Yield is a term that describes the current rate of interest you are effectively receiving.  Since bond prices fluctuate in the market, the rate you receive is only equal to the bond’s coupon rate when the bond trades exactly at par.  As a bond’s price moves up, your effective interest rate goes down and vice versa.  The two most common terms you will see when describing yield are YTM (Yield to Maturity) and YTW (Yield to Worst).  If the bond is NOT callable, these 2 numbers will be the same.  If the bond can be called, the YTM will represent your effective interest rate assuming you hold the bond to maturity and get your original principal back.  YTW represents the effective interest rate you will receive if the bond is called on the initial call date.

Now what?

Hopefully you have a much better picture of some of the key terminology people use when discussing bonds.  Tune in Monday for the second installment in our series where we will cover the major categories of bonds and some of their unique attributes.  Have questions?  Feel free to comment below and ask.

Photo Source