After an issuer sells a bond in the primary market, it will trade in the secondary market between investors (just like stocks). Bondholders are not obligated to hold their bonds for any set period; investors can even buy and sell their bonds on the same day. A bond’s market price is largely dependent on interest rates, just like preferred stock. Not only do interest rates influence a bond’s coupon when issued, but they also continually influence bond market prices. Bond values decrease when interest rates increase (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 in the primary market. The average market interest rate was 4% when you bought the bond. You’ll receive $40 annually from the bond through two semi-annual payments of $20. The interest you receive will not fluctuate or change over the bond’s life.
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 return 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 are few (or no) reasons 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 to $800? It would be much more marketable at this price. Remember, bonds mature at par, so the investor purchasing your bond would receive the 4% coupon plus the difference between their purchase price ($800) and the par value ($1,000). The investor earns an additional $200 over the bond’s life! The lower the price of your bond, the higher the yield (overall return) for the investor purchasing your bond. Of course, the lower you sell your bond, the bigger the loss you take as the selling party.
When a bond trades at any price lower than par ($1,000), it trades at a discount. Discount bonds give buying 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).
We also need to think through the alternate situation. Assume the same example, except interest rates fall to 2%. It will be easy if you want to sell your 4% bond in this market. Your bond pays an interest rate higher than the current rate 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 increased the price to $1,200? If another investor purchased your bond, they would receive a higher interest rate than the current market, but 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. Premium bonds pay ongoing semi-annual interest like any other bond (other than zero coupon bonds). 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 bond’s life. Investors purchase premium bonds because they offer higher interest payments than the average market rate.
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.
When interest rates change, bond values fluctuate in the market. Bonds with longer maturities and lower coupons tend to experience the most price volatility.
Bonds with long maturities tend to be more sensitive to interest rate changes because time has a compounding effect on market values. Assume you own a 1 year bond and a 20 year bond in your portfolio. When interest rates rise, the market values of both will fall, but the 20 year bond’s price will fall further. Within one year, the investor will receive their par value back on the 1 year bond. At that point, the investor can reinvest their money into a new bond with a higher interest rate. The other bond has a 20 year wait until that can happen. It’s locked in at the lower interest rate until it matures or is sold. Therefore, the 20 year bond is less desirable, resulting in its price falling further.
When interest rates fall, long-term bonds rise further in price for the same reasons. Going back to our comparison, the 1 year bond will rise in price, but not by much. It matures within one year; if the investor decides to reinvest their money back in the market, they will buy a bond with a lower rate of return unless they seek a much riskier bond. The 20 year bond has a higher interest rate that’s locked in for the next two decades. Because of this, the market value of the 20 year bond will rise further than the 1 year bond.
Bonds with lower coupons tend to be more sensitive to interest rate changes. To understand this, assume you own two 10 year bonds. One has a 2% coupon, and the other has a 10% coupon.
When interest rates rise, the value of both bonds will fall. The 2% bond will fall further because it has less interest to reinvest into the market at the new higher interest rate. The 10% bond pays more interest and gives more money to the bondholder to reinvest into the market at the new, higher interest rate. The lower a bond’s coupon, the more likely it was sold at a discount. If a bond’s value is primarily derived from the discount, the investor must wait until maturity to make money from the bond’s discount. The 10% bond is more valuable in this situation because the 10% bond pays more interest that can be reinvested at higher rates right now.
When interest rates fall, the value of both bonds will rise. The 2% bond rises further because its a big chunk of its value is tied to a discount. Remember, the lower the coupon, the more likely the bond was sold at a discount. When much of the bond’s value is achieved at maturity, there aren’t large sums to reinvest at the new lower interest rate. On the other hand, the 10% bond pays much more interest to its bondholder. If the bondholder reinvests the interest into the market, they are forced to buy bonds with lower rates of return. The 10% bond is less valuable in this situation because it pays more interest that would be reinvested at lower interest rates.
Here’s a video breakdown of a practice question regarding price volatility:
We learned how trades take time to settle in the common stock chapter. When an investor buys or sells a bond in the market, actions must be taken behind the scenes to reflect the new ownership properly.
For the issuer to make interest payments to the right investor, it must know who its current bondholders are. As it works with common stock, the transfer agent is responsible for keeping track of an issuer’s investors and making payments when they’re due. The transfer agent continually updates their book of bondholders when trades occur (adding buyers and removing sellers). Changing a bond’s ownership from the seller to the buyer takes time, settling in one business day. When an interest payment is due, the issuer provides funds to the transfer agent, who then distributes the interest payments to settled bondholders (as of the payment date).
We have yet to discuss the specific bond issuers, but there are three big categories:
US Government bonds
Municipal and corporate bonds
Some exceptions to these settlement times exist depending on the specific type of bond and how the trade is accomplished, but the exam usually sticks to these generalities. US Government trades settle through the Federal Funds system. Municipal and corporate trades settle through the Clearing House system, which is also the system you utilize for your personal banking.
Bonds pay semi-annual interest to their investors. When an interest payment is due, the transfer agent makes a payment to whoever owns the issuer’s bonds on the interest payment date. They do not prorate their payments, which creates a problem.
Assume an interest payment is due on Friday, July 1st. If an investor purchases this bond on Monday, June 27th, they will receive interest for the past six months, even though they’ve only owned the bond for four days. It seems unfair, doesn’t it? To fix this issue, the buyer pays the bond’s market price, plus accrued interest to the seller. To better understand this, let’s work through another example:
J&J 1 corporate bond trade occurs on Tuesday, April 11th
The new owner (buyer) will receive interest for the previous six months on July 1st, even though they didn’t own the bond for the entire six-month period. To resolve this issue, they pay accrued interest to the seller. Specifically, the buyer owes the seller for the time they held the bond from the last interest payment date (January 1st) up to, but not including the settlement date (April 12th). They owe the seller interest for January, February, March, and a few days in April. The new owner starts accruing their interest on the day the bond trade settles.
A testable point regarding accrued interest relates to how many days are considered while counting over months. Going back to our previous example, the bond trade settled on Wednesday, April 12th. Let’s focus on the two ways to count accrued interest:
30/360 method
For example:
A J&J 1 corporate bond trade settles on Wednesday, April 12th. How many days of accrued interest does the buyer owe the seller?
Can you figure it out?
January: 30 days
February: 30 days
March: 30 days
April: 11 days
Overall accrued interest days: 101 days
With the 30/360 method, we always assume 30 days in the months we count over (even though there are not 30 days in January, February, or March). For the month the bond settles in, we count the specific days (up to, but not including the settlement date).
Actual/365 (a.k.a. actual/actual) method
For example:
A J&J 1 US Government bond trade settles on Wednesday, April 12th. How many days of accrued interest does the buyer owe the seller?
Can you figure it out?
January: 31 days
February: 28 days
March: 31 days
April: 11 days
Overall accrued interest days: 101 days
Both methods produce the same amount of accrued interest days (101 days), but this isn’t always the case. There can be some differences between two bonds settling on the same date with the same interest payment schedule, although the difference should be insignificant.
When July 1st comes around, the buyer will receive interest for the last six months. The difference between the interest received from the issuer and what they paid to the seller for accrued interest is the exact amount of interest they’re due.
With the actual/365 method, we always count the actual days in the months we count over. You’re probably wondering if you need to memorize the days of each month. Thankfully, the SIE tends to focus on generalities, and it’s unlikely to encounter a question requiring a calculation of accrued interest days. The exam will more likely ask questions on what types of bonds use which methods (corporate & municipal use 30/360, while US Government bonds use actual/365).
If you’re planning to take the Series 7, you’ll need to know the days in each month because it’s likely you’ll see in-depth accrued interest calculation questions.
Most bonds trade with accrued interest, but not all of them. For example, no accrued interest is due if a bond settles on the interest payment date. When this occurs, the seller receives the interest for the past six months, and the buyer begins to accrue interest for the next interest payment period. Also, zero coupon bonds don’t pay semi-annual interest, so there is no accrued interest to be paid. These bonds trade flat, meaning they trade without accrued interest.
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