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29 ways: Day 14

Try it: Five-minute bond boot camp Add to ...

Many retail investors are quite happy owning stocks. Buy low, sell high, collect some dividends along the way. Nothing could be simpler, right?

But give those same investors a bond and they’re reduced to flustered, sweaty-palmed amateurs. What do bond prices mean? Why do bonds fall when interest rates rise? And those bond coupons we keep hearing about, are they good at No Frills? (Sadly, no.)

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If you’ve ever been baffled by bonds, this Investor Clinic is for you. We’re going to explain some of the most common terms, then we’re going to walk you through the basics of – gasp! – bond pricing. Don’t worry, we’ll hold your hand through the scary parts.

Even if you prefer buying guaranteed investment certificates, getting a basic grounding in bonds will make you a more informed investor. In fact, we think you’ll find the following information quite bond-alicious.

WHAT DO BOND PRICES MEAN?

Bonds are priced using an index with a base value of 100. A bond priced above 100 is said to be trading at a premium, a bond below 100 is selling at a discount, and a bond selling at 100 is trading at par.

Example: Say you’re buying $5,000 in face value of a bond trading at 98. It would cost you $5,000 multiplied by 98/100, or $4,900 (plus accrued interest, but we’re trying to keep things simple).

WHAT’S A COUPON?

Just to confuse people, most bonds quote an annual coupon rate but pay interest semi-annually. A 6-per-cent coupon bond, for example, pays interest of 3 per cent, twice a year. (In the old days, investors would clip interest coupons from a bond certificate, but nowadays everything is done electronically).



Investor Education: Bonds



The coupon payment doesn’t change even if the price of the bond does. So, continuing with the example above, if our $5,000 bond has a 6-per-cent coupon, it pays $150 in interest every six months, whether the bond is trading at 102, 98, 100 or any other price.

WHAT IS YIELD?

When people talk about the yield of a bond, they’re usually referring to the yield-to-maturity. This is the average annual return the investor can expect by holding the bond until it matures.

The yield-to-maturity takes into account a bond’s current price and its coupon rate. If a bond is trading at a discount (that is, less than 100), the yield-to-maturity will be higher than the coupon rate. This makes sense because, at maturity, the investor will get back more than he paid for the bond.

Conversely, if a bond is trading at a premium, the yield-to-maturity will be lower than the coupon rate. If the bond is trading at par, the yield-to-maturity and coupon rate will be the same.

WHY DO BOND PRICES AND INTEREST RATES MOVE IN OPPOSITE DIRECTIONS?

This is perhaps the most puzzling aspect of bonds. But if you can wrap your head around the relationship between interest rates and bond prices, you’ll be well on your way to becoming a bond brainiac.

Let’s look at an example. Say you buy a newly issued bond at par, or 100, with a 5-per-cent coupon (for simplicity, we’ll ignore commissions). Because you’re buying the bond at face value, the yield-to-maturity on the bond is also 5 per cent.

Now, let’s assume the general level of interest rates rises to 6 per cent, maybe because of worsening credit conditions or increasing inflation. If you tried to sell your bond, would the buyer give you 100 for it?

Heck, no. If he gave you 100, he’d only be getting a yield of 5 per cent. But market interest rates have risen to 6 per cent, and he wants to get at least that. So he’ll offer less than 100 for your bond. (Now you can see why bond prices fall when interest rates rise.)

How much less will he pay you? Pricing bonds is a complex exercise, and we won’t try to explain it fully here. But it boils down to this: Take all of the bond’s coupon and principal payments in the future. Now work backward and figure out what each would be worth today, based on the prevailing level of interest rates (also known as the discount rate). Finally, add up all these present values and – voilà – that’s the price of your bond.

It’s similar to computing compound interest, except you’re starting with a final amount (the future value of all coupon and principal payments) and figuring out how much you have to invest now to get there. The higher the interest rate, the less money you need to put up initially, and vice-versa. This is another way of showing that bond prices and interest rates move in opposite directions.

WHY DO BOND PRICES FLUCTUATE, BUT GICs DON’T?

Many investors prefer GICs because their prices never go down. But that’s only because there is no active secondary market for buying and selling GICs. If there was, investors would be shocked to discover that GIC prices also buck up and down with interest rates.

But because the vast majority of investors hold GICs until maturity, these invisible fluctuations don’t matter. This leads to a final point about bonds. If you plan to hold your bonds to maturity, there is no reason to panic when prices fall. You’ll still get your principal back when the bond matures (assuming the company or government doesn’t default). The lower price is just the market’s way of saying that it is paying less today for a certain amount of cash tomorrow.

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Read more of Globe Investor's 29 Ways in 29 Days to be a better investor



Learn more about investing from John Heinzl The 2010 Investor Education series for beginner investors:

The 2010 Investor Education series for advanced investors:

Gail Bebee's weekly mentoring for our investor education contest winner:



Follow on Twitter: @johnheinzl

 

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