Bonds trade like any other securities in the investment marketplace. There is a price at which traders will buy your bonds, called the bid price, and a price where they will sell those same bonds, called the ask price. The difference between the bid price and the ask price is called the trader's mark-up, or spread. Since bonds trade in terms of yield, the bid and ask prices are stated as yields.
How Bonds Trade
The price benchmark in the bond market is the yield at which U.S. Treasury securities are trading. Corporate bonds and municipal bonds all trade at a spread to Treasuries, meaning each bond is valued in the marketplace according to its maturity and credit rating, and trades a certain number of basis points higher yield than a similar maturity Treasury. For example, an AA corporate bond with a 10-year maturity trades approximately 75 to 80 basis points higher in yield than the 10-year Treasury.
Yields as Prices
If the 10-year Treasury bond is yielding 2.5 percent, the 10-year AA corporate bond will be offered by a trader at 3.25 percent. This is the asked yield. Use a bond calculator to figure the corresponding dollar price of a 10-year 3.5 percent coupon corporate bond, the result is 102.117 or $1021.17 per $1000 face value bond. Sometimes the trader will quote a bond in terms of dollar price if he wants to win or lose a bid or sale of that particular bond. For example, if the trader wanted to make sure to sell the corporate bond, he might ask 102 for a yield of 3.26 percent. Since the buyer wants the highest yield, he will choose the bond offered at 102 instead of the bond offered at 3.25 percent.
The bid yield is always higher than the asked yield because the lower the dollar price, the higher the yield. When a trader is bidding on a bond, he must buy the bond at a low enough price that he can add his trader's mark-up and sell the bond at a higher dollar price, which is a lower yield. For example, the above corporate bond might have a bid price of 3.35 percent, which would be a dollar price of 101.264 or $1,012.64 per bond.
The trader who buys the corporate bond at 3.35 percent ($1,012.64) will ask 3.25 percent or $1,021.17 for a profit of $8.53 per bond. The spreads between bid and ask fluctuate according to the demand for that particular bond and the condition of the market. When interest rates are rising, the trader will bid lower so the spread will be wide. When interest rates are falling, the spreads tend to narrow.
- Federal Reserve Bank of New York: Understanding U.S. Government Securities Quotes
- New York University Stern School of Business; Money Market and Debt Instruments; Alex Shapiro
- "USA Today"; The Difference Between the Bid Price and Ask Price Is the Broker's Profit; Matt Krantz; August 2006
- Bonds Online: US Corporate Spreads
- Securities Industry and Financial Markets Association: Calculators
- Jupiterimages/Photos.com/Getty Images