Bonds don't trade like stocks. The pricing mechanisms that cause changes in thebond marketmay not seem nearly as intuitive as seeing a stock or mutual fund rise in value because equities trade on a value based on what they are expected to be worth in the future. It's based on potential earnings growth. Investors should be familiar withbond pricing conventions.
Key Takeaways
- The price of a bond is determined by discounting the expected cash flows to the present using a discount rate.
- The three primary influences on bond pricing on the open market are supply and demand, term to maturity, and credit quality.
- Bonds that are priced lower have higher yields.
- A call feature can have an impact on bond prices.
How Bonds Trade
Bonds trade based on stated contractual cash flows, a known series of interest and principal return. A bond’s attractiveness in the market is based on two key risk factors. The first is the interest rate it pays relative to a similar bond issued at today's rates, or the interest rate risk. The second is whether the issuer can still make the scheduled payments on those pre-determined dates and at maturity. This is referred to as credit risk.
Each bond has a par value and it can tradeat par, a premium, or a discount. The amount of interest paid on a bond is fixed but its current yield or the annual interest relative to the current market price fluctuates as the bond's price changes.
The price of a bond is determined by discounting the expected cash flows to the present using a discount rate. The three primary influences on bond pricing on the open market are term to maturity, credit quality, and supply and demand.
Pricing Moves
Bonds are issued with a setface valueand theytrade at parwhen the current price is equal to the face value. Bonds tradeat a premiumwhen the current price is higher than the face value. A $1,000 face value bond selling at $1,200 is trading at a premium.Discount bondsare the opposite, selling for less than the listed face value.
The interest paid on bonds is fixed so bonds that are priced lower have higher yields. They're more attractive to investors. A $1,000 face value bond with a 6% interest rate pays $60 in annual interest every year regardless of the current trading price because interest payments are fixed. That $60 interest payment creates a present yield of 7.5% when the bond is currently trading at $800. Supply and demand can influence the prices of all assets, including bonds.
In the secondary market, bond prices have an inverse relationship to interest rates, resulting in counterintuitive price movements when interest rates change. When the Federal Reserve raises interest rates, bondholders must accept lower prices to compete with new issuances. Conversely, when interest rates fall, the prices of existing bonds will tend to increase. However, this does not affect the yield payments for bondholders who hold until maturity.
Bonds with higher yields and lower prices usually have lower prices for a reason. These bonds are priced with higher yields to reflect their higher risks.
Term to Maturity
The age of a bond relative to its maturity has a significant effect on pricing. Bonds are typically paid in full when they mature, although some may be called and others might default. A bondholder is closer to receiving the face value as the maturity date approaches because the bond's price moves toward par as it ages.
Bonds with longer terms to maturity have higher interest rates and lower prices when the yield curve is normal because a longer term to maturity increases interest rate risk. Bonds with longer terms to maturity also have higher default risk because there's more time for credit quality to decline and for firms to default.
Credit Quality
The overall credit quality of a bond issuer has a substantial influence on bond prices during and after bond issuance. Firms with lower credit quality will initially have to pay higher interest rates to compensate investors for accepting higher default risk. A decrease in creditworthiness will also cause a decline in the bond price on the secondary market after the bond is issued. Lower bond prices mean higher bond yields that offset the increased default risk implied by lower credit quality.
Investors rely on bond ratings to measure credit quality. There are three primary rating agencies. The ratings they assign act as signals to investors about the creditworthiness and safety of the bonds. Bonds with poor ratings have a lower chance of repayment by the issuer because the prices of these bonds are also lower.
Pricing Callable Bonds
Investors should also be aware of the impact that a call feature has on bond prices. Callable bonds can be redeemed before the date of maturity at the issuer's discretion. These bonds have a higher risk if interest rates have gone down because of the possibility of early redemption. Declining interest rates make it more appealing to the issuer to redeem the bonds early. The investor will have to buy new bonds that pay lower interest rates.
A call feature won't greatly affect the bond's price if interest rates have gone up. The issuer is less likely to exercise the option to call the bond in this situation.
What Is the Secondary Market?
Bonds are bought and sold on secondary markets after they're initially issued by the company. Most bonds are traded this way.
What Is Par Value?
Par value is face value. It's effectively what a bond is worth at the time of issuance and it should be specified in the corporation's charter and on the ownership certificate. It has a direct effect on the value of a bond at maturity. It's sometimes referred to as nominal value.
What Is a Typical Term to Maturity?
Bond terms to maturity can range from as little as one year to more than 10 years. A short-term bond will mature in one to three years. Intermediate-term bonds mature in four to 10 years and long-term bonds won't reach maturity until more than 10 years have passed.
This can be an important factor in your investment tactics because maturity dictates that the issuer will repay the bond's par value plus interest when the specified term has passed if it hasn't been retired early.
The Bottom Line
A bond's price is determined on the open market based on three major factors: its term to maturity, credit quality, and supply and demand. Term to maturity can be a bit tricky because a bond may be callable. It may be a long-term bond with a term to maturity of 12 years but the issuer can redeem it after just one year if it comes with a call feature that allows this. A bond can be called because of a drop in interest rates or other factors.
You may want to avoid callable bonds if you have a very specific, long-term investment plan and you don't like surprises, but the surprise could be immaterial if the current interest rate has gone up. Perform due diligence in establishing a bond's credit quality and supply and demand before you jump in. At the very least, you'll want to consult with an investment advisor you can trust.
