Trading

Market prices

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:

• The 4% coupon payments, and
• The $200 difference between the $800 purchase price and the $1,000 par value at maturity

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:

• Coupon interest (paid semiannually)
• The gain from buying below par and receiving par at maturity

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:

• They receive ongoing semiannual interest (like most bonds, except zero coupon bonds)
• They lose money at maturity because they paid more than par

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.

Price volatility

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:

• One has a 2% coupon
• One has a 10% coupon

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. When rates rise, the 10% bond’s price falls less, because more of its return arrives as interest that can be reinvested right away at the new higher rates.

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 that interest has to be reinvested at the new lower rates, so the 10% bond’s price rises less.

Here’s a video breakdown of a practice question regarding price volatility:

Sidenote

Rate volatility

You may see a question about rate volatility, which measures changes in primary market rates. For example, 20-year corporate bond coupon rates might change from 4% to 5% in one year.

This can feel like it conflicts with price volatility, but it’s a different idea. Short-term rates are considered the most volatile because they start from a lower base, so a small change can be a large percentage change.

Assume the following changes occur over the next year:

• 1 year bond rate = 2% to 3%
• 30 year bond rate = 6% to 8%

The 1-year rate rose by 1 percentage point, while the 30-year rate rose by 2 percentage points. At first glance, the 30-year rate looks more volatile. But rate volatility is measured as a percentage change from the starting rate:

• 2% to 3% is a 50% change (a 1-point rise from a 2% start)
• 6% to 8% is a 33% change (a 2-point rise from a 6% start)

Measured that way, the 1-year rate was the more volatile of the two.

Bottom line, here’s what you need to know for the exam:

• Price volatility = long maturity and low coupon
• Rate volatility = short-term rates

Settlement

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 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
• Corporate
• Municipal

US Government bonds

• Settle one business day after trade (T+1)
• Settle through the Federal Funds system (questions may say they settle in “federal funds”)

Municipal and corporate bonds

• Settle one business day after trade (T+1)
• Settle through the Clearing House system (questions may say they settle in “clearing house funds”)

Federal funds move between banks through the Federal Reserve and are available immediately. Clearing house funds move through the check-clearing system banks use for everyday payments. Some exceptions exist depending on the bond type and how the trade is executed, but the exam usually focuses on these general rules.

T+1 counts business days, not calendar days, so weekends and holidays are skipped. A bond that trades on a Friday settles the following Monday, or on Tuesday if Monday is a holiday.

Accrued interest

A bond earns interest every day, but it pays that interest only twice a year. Interest that has built up since the last payment but hasn’t been paid yet is called accrued interest.

That timing creates a problem when a bond changes hands between payment dates. On the payment date, the transfer agent pays the full six months of interest to whoever owns the bond. It doesn’t split the payment based on how long each investor held the bond during the period.

For example, assume an interest payment is due on Friday, July 1st, and an investor buys the bond on Monday, June 27th. Without an adjustment, the buyer would collect six months of interest for owning the bond only a few days, and the seller would get nothing for the months they held it.

To make it fair, the buyer pays the seller the bond’s market price plus accrued interest, which covers the interest the bond earned while the seller owned it. On the next payment date, the buyer receives the full six months of interest from the issuer. Part of that payment reimburses the buyer for the accrued interest they paid the seller, and the rest is the interest the buyer earned while they owned the bond.

Let’s work through a trade.

A $1,000 par, 4% J&J1 corporate bond trades on Tuesday, April 11th.

“J&J1” (sometimes written “J&J 1”) is shorthand for the bond’s payment schedule: it pays interest in January and July, on the 1st of the month. You’ll see this shorthand in exam questions. A 4% bond pays $40 of interest a year, so each semiannual payment is $20.

Corporate bonds settle one business day after the trade (T+1), so this trade settles on Wednesday, April 12th. The settlement date is when ownership changes, so it’s the date that splits the interest between the two investors:

• The seller earned interest from the last payment date (January 1st) up to, but not including, the settlement date (April 12th).
• The buyer starts earning interest on the settlement date, April 12th.

So the buyer owes the seller accrued interest for January, February, March, and April 1st through 11th.

Interest accrues every calendar day, including weekends, even though settlement is counted in business days. If this bond had traded on a Friday, it would settle on Monday, and the seller would be owed interest through Sunday. If Monday were a holiday, it would settle on Tuesday instead, and the seller would be owed interest through Monday.

How many days the buyer owes depends on the day-count method.

30/360 method

• Used for corporate and municipal bonds
• Assumes every full month in the accrual period (every month “counted over”) has 30 days, even if it actually has 31 or 28
• In the settlement month, counts the actual days up to, but not including, the settlement date

The J&J1 corporate bond settles on Wednesday, April 12th. How many days of accrued interest does the buyer owe the seller?

Can you figure it out?

Actual/365 (a.k.a. actual/actual) method

• Used for US Government bonds
• Counts the actual number of days in each month

Suppose the same J&J1 bond were a US Government bond settling on Wednesday, April 12th. How many days of accrued interest would the buyer owe the seller?

Can you figure it out?

Both methods happen to produce 101 days here, but that won’t always happen. The same trade can produce slightly different day counts under the two methods, although the difference is usually small.

Once you know the days, the dollar amount follows. Under 30/360, a year of interest is spread over 360 days, so the corporate bond’s accrued interest is:

$\text{Accrued interest}=\text{annual interest}\times \frac{\text{days}}{\text{360}}$

$\text{Accrued interest}=\text{\$40}\times \frac{\text{101}}{\text{360}}$

$\text{Accrued interest}=\$11.22$

The buyer pays the seller the bond’s market price plus $11.22. On July 1st, the issuer pays the buyer the full $20 interest payment. The first $11.22 of it reimburses the buyer, and the remaining $8.78 is the interest the buyer earned from April 12th through June 30th (79 days). The seller is paid for 101 days and the buyer for 79, which together make up the full 180-day period.

In other words, the interest the buyer actually earns equals the interest received from the issuer minus the accrued interest paid to the seller.

For the SIE, questions usually focus on which bonds use which method (corporate and municipal bonds use 30/360; US Government bonds use actual/365) rather than on detailed calculations.

If you’re planning to take the Series 7, you’ll need to know the days in each month, because detailed accrued interest calculations are more likely there.

Most bonds trade with accrued interest, but not all. A bond that trades without accrued interest trades flat:

• Settlement on the payment date: No accrued interest is due. The seller receives the interest for the prior six months, and the buyer begins accruing interest for the next period.
• Zero coupon bonds: These don’t make semiannual interest payments, so there’s no accrued interest to pay.