How Do Bonds Work?

Ever asked yourself, “How do bonds work?”  Have you noticed that as interest rates rise, bond prices decline?  Have you noticed that the opposite of this is also true?  If this phenomenon puzzles you, you’ll be happy to read the following post (it also explains to a large degree how preferred shares work too).

Bonds are basically a loan. When you buy a bond, you are loaning someone money.  At the end of the term, (you hope) they pay you back the money you lent out.  If they don’t repay your personal loan, you go into the personal debt collection business.  If they don’t repay your bond, you sue the company and bring them to bankruptcy court.

During the term of the loan, you receive interest payments.  In the case of bonds, you’ll receive those payments every six months. And those interest payments – and the prevailing and changing interest rate available in the market – are what moves the price of the bond.

Let’s take a look: Assume you buy a bond for $100,000 when market interest rates are 5% and the bond interest rate is also 5%.  You’ll receive $5,000 each year you hold the bond – two payments of $2,500 every six months.

In Year 2, let’s assume interest rates go up to 10% in the market and you decide you’d like to sell your bond and get that higher interest rate.  Your income on the existing bond is still 5% — the nominal rate never changes and the income dollar amount doesn’t ever change. Let’s say you come to me and offer to sell your bond for the price you paid — $100,000.  Am I going to buy it?  No way.  Why not?  Well, the income I’ll receive is $5,000 – remember, that doesn’t change.  But since prevailing interest rates are now up to 10%, how much would I have to invest to get a payment of $5,000 every year?  The answer is $50,000.  I could invest $50,000 and, since prevailing interest rates are 10%, I should be able to get a payment of $5,000.

So why would I buy your bond for $100,000 when I could invest $50,000 and duplicate the same income you are receiving?  The answer is, I wouldn’t.  And if you want to sell your bond, the most you’ll get is $50,000 for it.  Nobody cares what you paid for the bond.  Now, let’s assume you didn’t sell the bond because you didn’t want to lose so much money.  In Year 3, you get lucky.  Interest rates drop to 2.5%.  Now with those interest rates, I’d have to invest $200,000 in order to get $5,000 in interest right? That means your bond is now worth $200,000 and you won’t accept a penny less if you want to sell it.

So we’ve just explained why bond prices move inversely with interest rates.  Now, keep in mind that there are other forces that move bond prices as well.  One biggie is what the market thinks about the bond issuer’s ability to make payments and repay the loan completely.  If the borrow is thought to be unable to make interest and/or principal payments, nobody will want that bond.  It will be a junk bond and the price will drop.

So the credit quality of the issues impacts the price of the bond.  And as the credit quality of the issuer changes, the value of the bond will fluctuate.  Now go out there and impress all your investor friends with this newfound knowledge!