Bonds can be a daunting subject. You see their prices changing and the yields varying, but how does all that work? What does it mean when bond prices are high and yields are low, and what happens if the environment changes?
Let's take a look at the way bond prices work.
Bond pricing basics
At their most basic, bonds are a series of promised payments in exchange for a lump sum of money today. Most bonds make regular interest payments, called the "coupon," and at the end of a certain amount of time the borrower pays the original bond value, or the "principal." Essentially, the price of a bond is a simple math problem: Take each of those payments, discount their values back to today, and you have the net present value of the bond.
Of course, there are a lot of other factors involved in bond pricing, credit risk being a big one. A bond backed by collateral will be worth more (and pay less interest) than a bond that isn't backed by collateral, just like a bond issued by a reputable company with a strong credit history will be worth more than a bond from a cash-strapped upstart.
But wait, there's more: Interest rate changes
Bond values also change over time to reflect changing market and interest rate conditions. It's the interest rate that most often confuses people. For example, why is it that low interest rates beget high bond prices?
Let's say you're a company that issued bonds when the risk-free rate was 3%. Your bond is backed by collateral, so you don't need to add that much interest on top of that to make your creditors happy -- say 2%. Let's pretend that you've just issued a $100 bond that pays out $5 per year to investors.
One year later, interest rates go down. Now, the risk-free rate is only 1%, meaning that you could issue the same bond today and only pay $3 per year. You're a little bummed, but that's a different story. The market is looking at your bond, which pays 5%, and it's looking at all the bonds that look exactly like yours that are only paying 3%. The market is thinking, "The one paying 5% is worth more money."
How interest rates affect bond prices
Think about this from the perspective of efficiency: at any given time, bonds that look alike should be paying the same interest rate, right? The price of the bond with a higher coupon will go up until the yield -- that is, the actual amount of return investors are getting -- falls to the same level as all of its twin brothers and sisters.
In other words, the extra $2 your bond is paying every year is worth something. The price of your bond will rise until it's effectively paying out (or yielding) $3 per year instead of $5. You're still paying $5 no matter what the market does, but the return to an investor on the secondary market changes depending on the price he or she paid for the bond.
Visually, the relationship looks like this:
Bonds are actually quite complicated, and there are a number of factors that can affect their price. These range from adjustments to value based on coupons that have already been paid to pricing in special features like call options (which allow the issuer to buy back the bond at a certain date.) While you can get intimately involved with the math if that's your thing, the important basics to remember are the credit risks involved with bonds and the way that bond prices respond to interest rates. From here you can tackle the more complicated stuff much more easily.
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