Bond Basics Buying and Selling
Bond Basics Buying and Selling
Understanding Bonds: Buying, Selling, and Making Them Work for You
Bonds are an essential tool for diversifying your investment portfolio and managing risk. However, navigating the world of bonds can be a bit overwhelming. Knowing how to buy and sell bonds is just as important as understanding why you should invest in them. In this article, we will explore the basics of buying and selling bonds and provide you with valuable insights to help make bonds work for you.
How Bonds are Priced
Every bond has a face value or par value, which is the predetermined price set by the issuing company or governmental agency. This face value represents the amount the bond will pay when it matures. However, most bonds are sold either at a discount or a premium to their face value. The ultimate selling price of a bond is determined by the market.
Discount bonds are sold below their face value, while premium bonds are sold at a price higher than their face value. When determining a bond’s selling price, several factors come into play, including supply and demand, changes in interest rates, and the issuer’s credit rating. The majority of discounts in bond prices are primarily influenced by fluctuations in interest rates.
Bond Prices and Interest Rates
The relationship between bond prices and interest rates is inverse. When interest rates rise, bond prices fall, and when interest rates decline, bond prices rise. To illustrate this, let’s consider a hypothetical 30-year corporate bond issued 20 years ago with a 5% coupon interest rate and a $1,000 face value. This bond has been paying $50 annually for the past 20 years, with ten years remaining until maturity.
Now, if you were to buy this bond today, you wouldn’t pay $1,000 because interest rates have risen since it was issued. You would expect to earn more than $50 for every $1,000 you invest in bonds now. So, at what price would this 5% bond become a good buy? Let’s do some simple math to find out.
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Comparing the Current Yield
To assess whether the bond is a good buy, we start by comparing its current yield to other available bonds. The current yield is the annual interest payment divided by the current price. In other words, the current price is the annual payment divided by the current yield.
Assuming other bonds available in the market are yielding 6.9%, the bond you’re considering should yield the same or higher. To calculate the fair price for this bond, we use the formula: Price = 50/0.069 = $725 (rounded off). Therefore, $725 would be a fair price for this bond.
Calculating the Yield to Maturity
Next, we need to determine the bond’s yield to maturity. The 5% bond pays $50 a year and will be redeemed in ten years at its par value of $1,000. However, the current price indicated by the prevailing interest rates suggests a discount of $275. To approximate the yield to maturity, we use the following shortcut formula:
Annual interest + Annually accumulated discount / Average of par value and current price x 100
For the bond in our example: 50 + 28 = 78/860 = .09069 x 100 = 9.06% ≈ 9.1%
This formula can be used for bonds sold at a premium as well. In such cases, you would subtract the annually accumulated premium from the annual interest payment.
Don’t worry if these calculations seem complex. It’s important to understand and consider these factors when evaluating the value of a bond you may buy or sell at a discount.
Three Key Considerations
Now that you have a better understanding of bond pricing, here are three crucial factors to keep in mind when buying and selling bonds:
1. Stay up to date on the credit rating: It is essential to regularly check the credit ratings of the bonds you own. Ratings can change due to shifts in the issuer’s financial health or market conditions. Monitoring the financial health of the companies you’ve invested in is an excellent way to ensure the stability of your portfolio.
2. Be sure there’s an easy exit: Although you may intend to hold a bond until maturity, circumstances may arise where you need to sell it earlier. Marketability and liquidity are important considerations. It is advisable for ordinary investors to focus on investment-grade bonds that are easily priced and sold to other investors. Having an exit strategy during difficult times ensures you can get the most out of your investments.
3. Watch your maturities: When selecting bonds, try to align their maturity dates with anticipated expenses, such as college tuition, retirement, or planned reinvestment. Some investments automatically cash you out, while others require you to take an affirmative step to redeem your bonds. Having a plan for where the money goes next is crucial. If you have three months or more, you can consider short-term investments like certificates of deposit (CDs) or high-yield savings accounts to earn more interest while keeping the principal safe.
The Bottom Line
Bonds may seem complicated when considering interest payments, current yields, and yields to maturity. However, understanding these terms and their impact on a bond’s value is crucial. Knowing what you own and its worth allows you to evaluate the performance of your investments and plan better for future endeavors.
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