Pricing Bonds for Profit
It’s important that you understand how bonds are priced if you’re considering owning one or more of them. In its purest form, the way a bond works is simple to understand. However, most people never own a bond in this way, so it becomes important that you understand how they are actually priced in the market. Let’s look at the purest form first….
A bond is a promise by the issuer (a government or a corporation) to repay a loan to the lender (investor- you in this case). You and many others lend money to the issuer with a set understanding of what will occur in the future. So long as the issuer stays solvent, you will receive exactly what is promised. If the issuer goes bankrupt, you and the other bondholders will have the right to sell off their assets which will hopefully be enough to return your original principal.
An example might look like this….
You buy a $1000 bond issued to you directly by ABC Company which promises to pay you back 5% over the next 10 years with a semi-annual dividend payout schedule. At the end of the 10 years, they will repay you your original $1000.
As long as this company is adequately capitalized, well managed, and slightly profitable, you should receive everything exactly as promised. However, if you buy or sell the bond on the secondary market or if you are buying this bond as one of many managed in a portfolio of a mutual fund or ETF, then this is not how the transaction will go for you! It’s a little more complicated.
Bonds have different credit ratings which are determined by third party ratings agencies. The rating that a company or government has will determine the percentage rate of interest that they will have to pay on the bond when it is issued among other considerations. A couple other factors are the going market rate of interest and the duration (length) of the bond.
If one of these factors changes (and interest rates are constantly changing) then the price that you would buy or sell the bond at would change. So if you are buying a bond on the secondary market (from another investor.) then you will probably not be buying this bond for exactly $1000. The same applies when you are selling a bond. So for instance, if the company’s financial situation deteriorates while you are holding the bond, then you will probably have to accept less than you paid or it if you want to sell it. This is because the new buyer will demand a higher interest rate to compensate him for the risk associated with the bond.
This works for a very similar reason as bond prices changes due to interest rate changes. Because those constantly happen, they are more common then bond ratings changes, so we will give you an example there, but if you come back and think about it, you should be able to see why a bond price would fall on a bond whose rating has fallen in the same way that a bond price would fall if market interest rates rise.
Some other posts on Bonds we’ve done are: What is a Bond?, Treasury Inflation Protected Bonds, Shorting Treasury Bonds, Treasuries Might Be Risky, Are Other Bonds Risky?, & The Different Types of Bonds