Market prices

A bond is initially sold in the primary market, which provides the issuer the borrowed capital (money) it must pay back over time. After this initial sale, the bonds trade in the secondary market between investors. Bondholders are under no obligation to hold their bonds for any set period of time; investors can even buy and sell their bonds on the same day. The market price of bonds is largely dependent on interest rates, just like preferred stock.

Bond prices fluctuate in the market based on various factors. The most common factor is changing interest rates. Not only do interest rates influence the coupon of the bond when it’s issued, but they also continually influence bond market prices. Bond market values adjust to interest rate changes just like preferred stock market values. When interest rates go up, bond values go down (and vice versa).

To reiterate this point, let’s work through an example. Assume you purchase a 20-year, $1,000 par, 4% bond at par from the issuer during the bond’s initial public offering (IPO). At the time you bought the bond, the average market interest rate was 4%. You’ll receive $40 annually from the bond through two semi-annual payments of $20. The amount of interest you receive will not fluctuate or change over the life of the bond.

As a few years pass by, interest rates will change. Let’s say they rise to 6%, which would not be good for your bond’s value. If you tried to go back to the market and sell your bond for your original purchase price of $1,000, you probably wouldn’t find a buyer. Why? Your bond is competing with new 6% bonds being issued at par. There aren’t many reasons why an investor would prefer your 4% bond that pays $40 annually over a 6% bond paying $60 annually.

You might not be able to sell your bond for $1,000, but what if you dropped the price? If you dropped your bond to $800, it would be much more marketable. Remember, bonds mature at par, so the investor purchasing your bond would make the 4% coupon, plus the difference of their purchase price ($800) and the par value ($1,000). That’s an additional $200 the investor earns over the life of the bond! The lower the price of your bond, the higher the yield (overall return) for the investor purchasing your bond.

When a bond trades at any price lower than par ($1,000), it trades at a discount. Discount bonds give their investors two different forms of return. First, the coupon provides ongoing semi-annual interest. Second, the investor receives the difference between the purchase price and the maturity value (par). If another investor purchased your bond in the previous example, they would receive $40 annually in interest, plus the $200 discount over the life of the bond.

We also need to think through the alternate situation. Assume the same example, except interest rates fall to 2%. If you want to sell your 4% bond in the market, it won’t be very difficult. Your bond is paying an interest rate that’s higher than the current rate of interest in the market. When bond investors are searching for bonds to invest in, most new issues are being offered at around 2%. Your bond is attractive!

If you attempted to sell your 4% bond for $1,000, it would be sold immediately. The demand for your higher interest rate bond will allow you to raise the market price and still sell the bond. What if you raised the price to $1,200? If another investor purchased your bond, they would receive a higher rate of interest than the current market, but they would lose some return based on the bond’s purchase price.

When a bond trades at any price higher than par ($1,000), it trades at a premium. Premium bonds give their investors conflicting returns and losses. Just like any other bond (other than zero coupon bonds), premium bonds pay ongoing semi-annual interest. However, the investor loses money on the difference between their purchase price and the maturity value (par). If an investor purchased your bond in the previous example, they would receive $40 annually in interest but would lose $200 over the life of the bond.

How can an investor determine which bond provides the highest rate of return if they’re looking at several different bonds? In a future section, we’ll discuss how a bond’s yield answers this question.