Many people view bonds as a relatively stable investment offering regular income and understand they are a form of debt used by companies and governments. However, when it comes to the ins and outs of bond pricing and performance, many investors may find a gap in their knowledge.
How bonds are priced
When it comes to bonds, there are two types of "pricing" an investor needs to understand. The first is the initial price of the bond – or its face value – which is set when the bond is first issued to the market. This is also the amount of capital that will be returned to the investor at maturity barring a default.
The second relates to the price of the bond as it trades in the secondary market. Such prices are quoted as a percentage of the bond’s face value. For example, if the face value is $1000 and the quoted market price is $990, then the bond price is quoted as 99. Similarly, if the market price is $1010, the bond is trading at a price of 101.
When the bond price is higher than its face value, it’s described as trading at a premium to par. On the other hand, when the bond price is lower than its face value, it is said to be trading at a discount to par.
This concept is illustrated in the table below:
||PRICE QUOTED AS
||THE BOND IS TRADING AT
||A premium to par
||A discount to par
Why bond prices move up and down
Investors who plan on holding their bond until maturity typically don’t need to worry about the movement of bond prices on the secondary market as they will be repaid their principal in full at maturity, barring a default. But for those looking to sell their securities sooner, an understanding of what drives secondary market performance is essential.
The price of a bond relative to yield is key to understanding how a bond is valued. Essentially, the price of a bond goes up and down depending on the value of the income provided by its coupon payments relative to broader interest rates.
If prevailing interest rates increase above the bond’s coupon rate, the bond becomes less attractive. In this situation, the bond price drops to compensate for the less attractive yield. Conversely, if the prevailing interest rate drops below the bond’s coupon rate, the price of the bond goes up as it becomes more attractive.
For example, if a bond has a 4% coupon and the prevailing interest rate rises to 5%, the bond becomes less attractive and so its price will fall. On the other hand, if a bond has a 4% coupon and the prevailing interest rate falls to 3%, that bond becomes more attractive which pushes up its price on the secondary market.
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Factors that influence the performance of bonds
Apart from interest rate movements, there are three other key factors that can affect the performance of a bond: market conditions, the age of a bond and its rating. Let’s look at each in turn.
- Market conditions
Broader market conditions can have an impact on bonds. For example, if the stock market is rising, investors typically move out of bonds and into equities. By contrast, when the stock market is going through a correction, investors may seek the perceived safety of bonds.
Bonds are assigned credit ratings by ratings agencies, such as Moody’s and Standard & Poor’s. The ratings signal to investors the agency’s view of the issuer’s ability to pay the interest and principal when due. If a bond’s credit rating is downgraded, the bond becomes less attractive to investors and its price will likely fall.
- The age of a bond
The age of a bond relative to its maturity date can affect pricing. This is because the bondholder is paid the full face value of the bond when the bond reaches maturity. As the maturity date gets closer, the bond's price will move towards par. The diagram below shows the effect of time on the price of a bond when the prevailing interest rate is 5%.
What this chart tells us
- Blue line (at par) – The blue line that runs across the middle of the chart represents a bond that has a coupon of 5% - the same as the current prevailing interest rate. As such, this price of this bond is also at par ($100)
- Green line (premium to par) – The green line represents a bond offering a coupon of 10%. Because it is paying more than the prevailing interest rate of 5%, it costs more to buy ($180 instead of $100).
- Navy line (discount to par) – The navy line represents a bond offering a coupon of 3%, which is below the prevailing interest rate of 5%. As such, this bond costs less to buy ($70).
All three bonds converge on the same price at maturity because they will all repay the same face value amount of $100.