When there's a stock market downturn -- and there have been a couple of them in the last decade -- the interest in bond investing perks up. The first lesson in bond investing is that when yield goes up, prices go down, and vice versa. However, it's not quite that simple.
There are two ways to invest in bonds. The first is to buy a bond when it's issued at its face value -- usually $1,000 -- and collect the coupon, the stated interest rate for the life of the bond. Most bonds have a fixed coupon, so if you hold a 5 percent coupon bond, you'll collect $50 a year, and then get your principal back when the bond matures. The second way to invest in bonds is to buy and sell them on the open market. Although you still will collect the coupon, the price you pay or receive for the bond on the open market fluctuates based on the prevailing interest rate.
Fixing The Price
With stocks or mutual fund shares, you know the price. A stock is traded throughout the day and a mutual fund's share price -- or net asset value -- is reported at the end of every trading day. However, bond prices generally are derived prices set by industry pricing providers who consider many factors, primarily coupon rate, bond maturity and prevailing interest rates.
Rates Effect On Price
The coupon typically remains fixed for the life of the bond. A typical $1,000 bond with a 6 percent coupon rate, pays $60 a year. When rates rise to 7 percent, if you want to sell your bond, the price will need to be at whatever price will bring a 7 percent yield. That happens to be $857.14, which means you will give up $142.86 if you sell your bond. But if rates go down to 5 percent, you'll expect the buyer to pay you a premium to get $60 a year. Now, your bond is worth $1,200, a 20 percent markup.
Maturity's Effect On Price
Bond pricing actually is a little more complicated than simply factoring in coupon rates. The rates typically rise and fall only a few hundredths of a percentage point day to day. But the change in bond prices can be more dramatic, depending on the length of the bond. "Yield to maturity" calculates the return an investor will get if the bond is held until the bond expires. That yield is boosted because it factors in reinvesting the interest over the life of the bond, and it can be further boosted if the buyer bought the bond below its face value. Because the yield to maturity can build through the power of compounding during added years over the life of a bond, interest rate changes affect long-term bonds more dramatically.
Because most bonds have a face or par value of $1,000, bond prices are quoted as a percentage of par. A bond price quote of 91.63 would mean the bond would cost you $916.30. Similarly, a quote of 101.6 would mean the bond would cost $1,016.
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