After an issuer sells a bond in the primary market, it can trade in the secondary market between investors (similar to stocks). Bondholders aren’t required to hold a bond for any set period - you can buy and sell bonds at any time, even on the same day.
A bond’s market price depends heavily on interest rates, similar to preferred stock. Interest rates affect the coupon rate when a bond is issued, and they continue to affect the bond’s market price after issuance. Bond values decrease when interest rates increase (and vice versa).
To see why, work through this example.
Assume you purchase a 20-year, $1,000 par, 4% bond at par from the issuer in the primary market. At the time you buy it, the average market interest rate is 4%. You’ll receive $40 per year in interest, paid as two semiannual payments of $20. That coupon payment doesn’t change over the life of the bond.
A few years later, interest rates rise to 6%. That’s bad for your bond’s market value. If you try to sell your bond for your original $1,000 purchase price, you’ll probably struggle to find a buyer. Why? Your 4% bond is now competing with newly issued 6% bonds selling at par. Most investors would rather buy a 6% bond paying $60 per year than your 4% bond paying $40 per year.
You may not be able to sell for $1,000, but what if you lower the price to $800? At $800, your bond becomes more attractive. Remember: bonds mature at par, so the investor who buys your bond for $800 will receive:
That $200 increases the buyer’s overall return. In general, the lower the bond’s price, the higher the yield (overall return) for the buyer. From your perspective as the seller, a lower sale price means a larger loss.
When a bond trades at any price lower than par ($1,000), it trades at a discount. Discount bonds give investors two sources of return:
Now consider the opposite situation. Assume the same bond, but interest rates fall to 2%. Selling your 4% bond becomes easy because it pays more than the current market rate. Most new issues are being offered around 2%, so your bond stands out.
If you offer your 4% bond at $1,000, it will likely sell quickly. In fact, strong demand may allow you to raise the price and still find a buyer. Suppose you raise the price to $1,200. The buyer still gets the higher coupon rate, but they’ll give up some return because they paid more than par.
When a bond trades at any price higher than par ($1,000), it trades at a premium. Premium bonds create a tradeoff for the buyer:
In the $1,200 example, the investor receives $40 per year in interest but loses $200 over the bond’s life when it matures at $1,000. Investors still buy premium bonds because the coupon payments are higher than the average market rate.
How do you compare returns across different bonds? A future section explains how a bond’s yield answers that question.
When interest rates change, bond prices move. Bonds with longer maturities and lower coupons tend to experience the most price volatility.
Bonds with long maturities are more sensitive to interest rate changes because time magnifies the impact on market value. Suppose you own a 1-year bond and a 20-year bond.
When interest rates rise, the market values of both bonds fall, but the 20-year bond typically falls more. The 1-year bond returns par soon, and the investor can reinvest at the new higher rate. The 20-year bond locks the investor into the lower coupon for much longer (unless it’s sold), so it becomes less desirable and its price drops further.
When interest rates fall, long-term bonds typically rise more for the same reason. The 1-year bond matures soon, so the investor will have to reinvest at lower rates. The 20-year bond locks in the higher coupon for decades, so investors value it more and its price rises further.
Bonds with lower coupons also tend to be more sensitive to interest rate changes. Assume you own two 10-year bonds:
When interest rates rise, the value of both bonds falls. The 2% bond usually falls further because it provides less interest income to reinvest at the new higher rates. The 10% bond pays more interest, giving the bondholder more cash flow to reinvest at higher rates right away.
Also, the lower a bond’s coupon, the more likely it was sold at a discount. If much of a bond’s value comes from the discount, the investor must wait until maturity to realize that part of the return. In a rising-rate environment, the 10% bond is more valuable because it delivers more interest income that can be reinvested immediately.
When interest rates fall, the value of both bonds rises. The 2% bond often rises further because a larger portion of its value may be tied to a discount that’s realized at maturity. With less interest income coming in, there’s less cash to reinvest at the new lower rates. By contrast, the 10% bond pays more interest, and reinvesting that interest now means accepting lower rates - making the 10% bond less valuable in this environment.
Here’s a video breakdown of a practice question regarding price volatility:
We learned in the common stock chapter that trades take time to settle. When an investor buys or sells a bond, back-office steps are required to update ownership records.
For the issuer to send interest payments to the correct investor, it must know who currently owns the bonds. As it works with common stock, the transfer agent tracks an issuer’s investors and makes payments when due. When trades occur, the transfer agent updates its records (adding buyers and removing sellers). Changing ownership from seller to buyer takes time; bond trades generally settle in one business day.
When an interest payment is due, the issuer provides funds to the transfer agent, and the transfer agent distributes interest to settled bondholders (as of the payment date).
We haven’t covered specific issuers yet, but there are three major categories:
US Government bonds
Municipal and corporate bonds
Some exceptions exist depending on the bond type and how the trade is executed, but the exam usually focuses on these general rules. US Government trades settle through the Federal Funds system. Municipal and corporate trades settle through the Clearing House system, which is also the system used for personal banking.
Bonds pay semiannual interest. When an interest payment is due, the transfer agent pays whoever owns the bond on the interest payment date. The issuer doesn’t prorate interest based on how long each investor held the bond during the period, which creates a fairness issue.
Assume an interest payment is due on Friday, July 1st. If an investor buys the bond on Monday, June 27th, they would receive interest for the entire prior six months - even though they only owned the bond for four days. To fix this, the buyer pays the bond’s market price plus accrued interest to the seller.
Here’s an example:
J&J 1 corporate bond trade occurs on Tuesday, April 11th
The buyer will receive the full six months of interest on July 1st, even though they didn’t own the bond for the entire period. To balance this out, the buyer pays accrued interest to the seller.
Specifically, the buyer owes the seller interest for the time the seller held the bond from the last interest payment date (January 1st) up to, but not including, the settlement date (April 12th). That includes January, February, March, and part of April. The buyer begins accruing interest on the settlement date.
A common exam point is how days are counted when calculating accrued interest. Using the same settlement date (Wednesday, April 12th), there are two counting methods:
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, assume 30 days for each full month counted over (even if the calendar month has 31 or 28 days). For the month the bond settles in, count the actual 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 number of accrued interest days here (101 days), but that won’t always happen. Two bonds with the same settlement date and payment schedule can produce slightly different day counts, although the difference should be insignificant.
When July 1st arrives, the buyer receives the full six months of interest from the issuer. The difference between (1) the interest received from the issuer and (2) the accrued interest paid to the seller equals the interest the buyer actually earned during the time they owned the bond.
With the actual/365 method, you count the actual days in each month. You might wonder whether you need to memorize the days in each month. For the SIE, questions usually focus on which bonds use which method (corporate & municipal use 30/360; US Government uses actual/365), not detailed day-count calculations.
If you’re planning to take the Series 7, you’ll need to know the days in each month because more detailed accrued interest calculations are more likely.
Most bonds trade with accrued interest, but not all. For example, no accrued interest is due if a bond settles on the interest payment date. In that case, the seller receives the interest for the prior six months, and the buyer begins accruing interest for the next period. Also, zero coupon bonds don’t pay semiannual interest, so there’s no accrued interest to pay. These bonds trade flat, meaning they trade without accrued interest.
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