Market prices

A bond is first sold in the primary market, where the issuer raises borrowed capital (money) that it must repay over time. After that initial sale, bonds trade in the secondary market between investors.

Bondholders aren’t required to hold a bond for any specific period. You can sell a bond whenever you want - even the same day you buy it. Like preferred stock, a bond’s market price is largely driven by interest rates.

Bond prices fluctuate for several reasons, but the most common is changing interest rates. Interest rates affect:

• The coupon rate set when the bond is issued
• The bond’s market price throughout its life

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 see why, let’s walk 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, interest rates will change. Suppose they rise to 6%. That’s bad for your bond’s market value. If you tried to sell your bond for your original purchase price of $1,000, you probably wouldn’t find a buyer.

Here’s why: your bond is now competing with new 6% bonds being issued at par. There aren’t many reasons an investor would choose your 4% bond (paying $40 annually) over a 6% bond (paying $60 annually).

So what happens if you lower the price? If you dropped your bond’s price to $800, it would be much more marketable. Remember, bonds mature at par, so an investor who buys your bond for $800 would earn:

• The 4% coupon payments, and
• The difference between the purchase price ($800) and the par value ($1,000)

That difference is an additional $200 earned 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 investors two forms of return:

• Ongoing semi-annual interest from the coupon
• The gain from receiving par at maturity after buying below par

If another investor purchased your bond in the example above, they would receive $40 annually in interest, plus the $200 discount over the life of the bond.

Now consider the opposite situation. Assume the same bond, but interest rates fall to 2%. If you want to sell your 4% bond in the market, it won’t be difficult. Your bond pays an interest rate that’s higher than the current market rate, so it’s more attractive than most new issues being offered at around 2%.

If you tried to sell your 4% bond for $1,000, it would likely sell immediately. Because demand is higher for a bond with a higher coupon, you may be able to raise the market price and still find a buyer.

For example, what if you raised the price to $1,200? An investor who buys at $1,200 still receives the $40 annual coupon, but they give up some return because the bond will still mature at $1,000.

When a bond trades at any price higher than par ($1,000), it trades at a premium. Premium bonds create a tradeoff for investors:

• They receive ongoing semi-annual interest from the coupon, but
• They lose money on the difference between the purchase price and the maturity value (par)

If an investor purchased your bond for $1,200 in this 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 when comparing several different bonds? In a future section, we’ll discuss how a bond’s yield answers this question.