Bond Prices – How Do They Work?

I have seen prices of individual bonds cause some confusion for many private investors. I’m referring here to normal bonds, not the new Solidarity Bond currently being promoted by the Irish Government.

Let’s tackle individual bond pricing.

And let’s use as an example:
- A Government (Irish) bond, with a 5 year maturity (maturity date 2015)
- Bought from a dealer on the date of issue, say 2010 at face value
- To keep things simple, let’s say the price is €10,000 for the bond, its face value
- The coupon is, say, 4%. That’s the interest rate on the face value

So, we lend the Irish Government €10,000 for 5 years. They in turn promise to pay us €400 (4% on €10,000) at the end of every year. At the end of the 5th year they promise to pay us the €400 interest and return the €10,000 principal.

Simple enough. We are earning €400 every year on our sum on money.

We could sell your bond on the open market (the stock market) but we don’t. We are happy getting the annual income of €400 and the €10,000 back in 2015.

Ok. Now let’s say the general market interest rates drop because of a slow-down in the economy, for example. Let’s also say the Irish Government now only needs to pay a coupon of 3% to be attractive to investors, not the 4% we were lucky enough to get.

What happens?

Nothing happens our bond, if we carry on holding it to maturity. We’ll get our €400 interest per annum and our €10,000 back in 2015. They promised that!

But say a friend of ours has cash to invest safely & wants to earn €400 interest per annum by buying a new Government Bond. With a coupon of now 3%, how much will he have to lend the Government to earn €400? Well, 3% of €13,333 is €400, so €13,333 would be the price of the bond for him!

Yo! we only paid €10,000 for the bond! Now the bond is worth €13,333! Quids in!

Well, yes! our bond is more valuable on the stock market when interest rates go down, because it now takes more money to earn that particular amount of interest!

Similarly, when interest rates rise, bonds become less valuable on the stock market because it takes less money to earn a particular amount of interest!

This is one of the main reasons the market value of bonds fluctuate – because of general longer term interest rate changes. And the market value of bonds generally move in the opposite direction to longer term interest rate changes.

But, if we hold onto our Government bond until it matures, this all doesn’t matter. Because, apart from receiving our regular interest payment, the face value of the bond will be returned on the maturity date too. Assuming of course, that the Government can pay its bills when the bond matures!

So shouldn’t we just sell the bond to make a quick profit if interest rates go down and the market value of bond goes up?

If income is important to us, what’s the point in doing that, because general interest rates have declined? If we did sell we may not be able to make the €400 interest safely & consistently elsewhere even with the larger amount of principal (the €13,333)!

What normally happens is that some bank or building society might try to tempt us with higher interest rates for a short while, only to drop them back “when we’re not looking”!!

The reality is, most people can’t be bothered to keep moving their money about to get the best interest rates, because it’s just too much hassle. So if we have a bond paying a decent interest rate for the longer term, it’s normally better just to hold it to maturity.

There are other reasons the market value of bonds fluctuate too, but they would usually be less important in terms of their impact.

Is our loan “guaranteed”? The Irish Government promises to pay the interest and repay the principal, so if the Government is as good as its promises then we are ok, we can regard it as “guaranteed”. The question being, what if a government defaults on its bonds? Never happened the Irish Government, but it has happened, though rarely!

Personally, I feel the word “guaranteed” should not be part of a serious investor’s vocabulary. I think any serious investor should have an excellent grasp of the concept of “investment risk” and have the insight to manage it within their own tolerance for investment risk. More on this in a future post.

As regards minimum investment in bonds, normally one might be investing a larger sum than the example I have given to make it work well, though €10,000 is possible. Personally, I feel the practical minimum would be about €50,000.

There will be some trading fees on top of the bond price. Each dealer will have their own fee structure. More details on the the Irish National Treasury Management Agency website (click to view).

And just reiterating a previous post, pricing of individual bonds works very differently to daily unit prices in a bond fund. I will cover unit prices in bond funds in a future post, not here.

Just note very well: bond funds don’t at all work the same way as individual bonds!

The information in this post applies to both individual Government bonds and Corporate bonds. The quality of Government bonds tends to be higher, and they tend to pay a lower coupon than Corporate bonds because of the lower investment risk.

As I’ve said in a previous post, individual bonds are relatively uncommon in private investor circles in Ireland, at least up to now.

This is a pity and a puzzle in my opinion because they fulfil an extremely important role in good investment practice. I would love to be part of promoting the role of bonds in Ireland!

For example, they could have helped greatly to moderate the major volatility (losses!!) suffered by many investors in more recent times.

Individual bonds have always been very important to private investors in countries such as the USA, Canada and the UK in more recent times.

Individual bonds may be suitable for more conservative investors, with medium to large lump sums to invest and who are prepared to hold them until maturity rather than try (and I emphasise ‘try’!) to speculate on short-term windfall gains.

Please do consult your qualified and experienced financial advisor regarding their suitability for your own circumstances. (Remember Red Adair: if you think hiring a professional is expensive, try hiring an amateur!)

And lastly, the statutory warning as required by the Irish Financial Services Regulatory Authority: the value of investments can decrease as well as increase and you could get back less that you originally invested!

That should not be news!! It has been the case since Adam was a little lad!

Comments, queries and opinions very welcome. Many thanks as always.

Related posts:

1. Bonds
2. Absolute Return Funds
3. Understanding Investment Risk
4. National Solidarity Bond
5. Diversification: Irish Stock Exchange & London