Bonds 101: Open Market Pricing
Introducing open market pricing, yields, and interest rates
This is the second article of a short series on understanding bonds and how they are intertwined with equity markets. If you missed it, I recommend you check out the first instalment before continuing:
Last week, we covered the fundamental characteristics of bonds as sold on the primary market (the marketplace for direct transactions between the issuer and the bond buyer). However, bonds are transferable instruments, meaning that they can be resold on the secondary market at any time. Today, we will explore how bonds are priced on the open market and what factors affect this pricing.
Why are bonds priced differently on the open market?
When a bond is first issued, its coupon (which you will remember is fixed) is set depending on the circumstances at that point in time — such as the current default risk of the issuer. As time goes on, these factors are likely to change. Thus, the price must change to reflect this.
This is not a new concept, most things you purchase have this same relationship. If you buy a Supreme t-shirt for £150 when it’s fashionable, and a year later Supreme isn’t cool, you won’t be surprised that you can’t resell it for that same sticker price on the open market.
The same principle applies if the creditworthiness of a company or country falls whilst owning a bond. If you want to resell it, you’re going to have to lower to price to make it attractive to other investors.
Introducing yields
A bond’s coupon is only an accurate representation of the annual interest rate a bondholder will receive if they pay face value for the bond. If the price an investor pays for a bond rises above or falls below the face value, the coupon is no longer an accurate representation of the interest rate they will effectively receive.
For example, let’s say the face value of a bond is $1000 and the coupon is 2%. If I pay $1000 for the bond, the $20 coupon payments I’m receiving each year are representative of a 2% annual interest rate.
However, if I pay $900 for the bond on the open market, I will still receive $20 each year as my annual coupon payment (because the face value and coupon cannot change). But the interest rate I am effectively receiving has risen to 2.2% — simply calculated as $20/$900. This is because, while the price of the bond has fallen, the interest payment has remained constant. Thus, the interest payment I am receiving is now larger relative to my initial investment.
This ‘effective interest rate’ is known as the yield, and is used to show investors the effective rate of return they will receive if they buy a bond at its current price. It is one of the most important indicators monitored by investors and economists in the bond market.
The yield I have calculated above is a very crude measure known as the current yield, which ignores the time value of money. A slightly more sophisticated measure is the ‘yield to maturity’, which we shall not cover today.
You may have noticed that while the price of the bond fell, the yield rose. This is another fundamental trait of bonds in the secondary market. There is an inverse relationship between the price of a bond and its yield.
You can think of this like a seesaw — as one side rises, the other must fall.
What factors affect bond prices?
Term to maturity
This is probably the most intuitive factor. In a bond that is closer to maturity (the final lump sum repayment of the face value), there are fewer coupon payments to be made to the bondholder. Therefore, as the maturity date approaches, the price of the bond moves towards its face value.
Changing creditworthiness
Investors demand to be compensated by a higher coupon payment to lend money to a riskier company. If the creditworthiness of the issuer worsens, the old coupon rate will be less attractive to investors. This is because it no longer provides a return that compensates for the true riskiness of the asset. So, to make it a more compelling offer on the secondary market, the price must be lowered, increasing the yield an investor will receive if they buy the bond.
In general, a higher yield signals higher risk.
Interest rates
The interest rate is one of the most significant factors affecting bond prices. The bottom line is that when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. The reason for this is logical.
When interest rates rise, new bonds that are issued come with an accompanying higher coupon rate. This renders older bonds, which were issued in a lower interest rate environment, with lower coupons, less attractive. Therefore, the prices of existing bonds in the market fall.
Next week
There is much more nuance in the pricing of bonds, especially between bonds and interest rates, than I have described above. As well as many other macro factors that come into play.
I will delve more into this in next week’s article, where I will provide context to what we have discussed so far, dissect the recent bond market tumult, and bring equity markets into the mix.
