How does bonds work ?

Sensei answered 5 months ago …

Bonds trade in a market, just like stocks. There's a "bid" and an "ask" and you buy them like stock. There are a number of factors that influence the price including, inter alia, the reliability of the borrower to make the interest payments during the life of the bond and its ability to pay back the principal at maturity. Your question relates to how interest rates affect the price. This is best explained by using an example.

Suppose that I own a $1,000 bond that pays interest at an annual rate of 5% - $50 a year. Because bonds are issued with a stipulated "coupon", that rate will not change over the life of the bond. Regardless of what is happening "in the market", the bond will never pay me more than $50 interest each year.

Let's assume for this example that the bank will pay me 5% interest on my savings account. All other things being equal, if I was to sell that bond, how much will you pay me for it? Probably $1,000. Since you can get 5% on your savings account (just like I can), you don't really care about HOW you own the "investment" so long as you can earn that $50 interest each year.

Now, suppose that interest rates go up and the bank will pay us 8% on savings accounts - $80 a year on $1,000. Now how much will you pay me for it? Well, if you paid me the face value, you'd still earn the bond's coupon rate - 5% - $50 a year. But wait! That means you'd lose $30 a year interest. Not a good idea, right? So, how will you make up for that? You want to earn that $80 in interest, and to do that, you'd would only pay me $625! ($50 interest / $625 you paid = 8% return on investment.)

So, what have we learned so far? When the bank was paying 5% interest, you were prepared to buy the bond for face value. But when the bank was willing to pay 8%, you were only willing to pay $625 for the same bond! So, when interest rates go up, bond prices go down. And it doesn't take a rocket scientist to figure out that the reverse is true - when interest rates go down, bond prices go up. Why? Because the interest rate attached to the bond is fixed whereas interest rates "on the street" can vary from day to day.

What happens if you buy the bond between interest payment dates? You have to pay the seller of the bond an amount equal to the accrued interest the bond has "earned" to that date in addition to the price you've agreed on. So, in the above example, if interest was only payable annually and you bought the bond half-way through the year, you'd pay me $625 for the bond PLUS $25 in accrued interest. That interest is a current "expense" for you and is tax deductible in the year you buy the bond.

A short story here as a total aside to help you understand what can happen ...

Up here in Canada, our government issues a particular debt each year called "Canada Savings Bonds". The peculiarity of these bonds is that they cannot be sold "in the market", but, even better than that, they are "instant cash whenever you need it" - they are redeemable at any bank on any day for their face value plus accrued interest. (Sorry, only Canadian resident individuals can buy them.)

Back in the mid-1980's, when interest rates were rocketing higher, the Bank of Canada was facing a torrent of redemptions. Why? Because the bonds could not be sold in the open market - even at a discount - and were paying interest at a rate that was significantly lower than the "market" (and getting worse every month.) Even bank accounts were paying more and people were cashing in the bonds like there was no tomorrow. (Remember, the bonds are instantly cashable at any time for face value plus accrued interest.) In order to prevent a further "run", the government announced that they'd pay "bonus" interest on the bonds in order to bring their value back to "market".