The primary driver of bond prices and the bond market is interest rates. Yes, you have to pay close attention to the quality of the corporation or government behind each bond, but the market itself is focused like a hungry hawk on what’s happening with interest rates. Now, I’m not going to get into all the highly technical jargon surrounding interest rates.
That will only put you to sleep. Instead, I’ll try to keep the discussion to just the two important rates you need to know about to make investment decisions. Even then I’ll keep things simple. They include the bond payout interest rate and market rates.
Bond Interest (Pay Out) Rate
So let’s get the first and obvious bond interest rate out of the way. It’s the interest rate that will be paid to bondholders (you, me, and other investors). The official name of this rate is the Coupon Rate.
It all starts with the corporation or government that is trying to raise money. They will work with smart investment bankers to determine a fair rate to pay you for borrowing your money. The investment bankers will closely examine current market conditions, the economy, etc.
Their job is to settle on a competitive interest (coupon) rate that will entice you to buy the bonds, while making sure the corporation or government issuer doesn’t give away the store. Truth be told, the rate that they end up with is usually very close the rates offered by similar bonds.
Anyway, if you purchase a $5,000 bond that pays a fixed interest rate of 4% annually until the bond matures in 3 years, then each year you’ll receive a check for $200.
At the end of the third year, you’ll receive your last interest payment along with your original investment amount. When it’s all said and done, you will have made a tidy profit of $600.
Now, there are some bonds where the face value might be $5,000, but you’ll only pay $4,400 upfront. In this case, the interest (or profit) is baked in. That’s because at the end of 3 years, you’ll get a single check for the full $5,000. This is called a Zero coupon bond.
So there are several ways that bonds can pay out interest, but these two are the most common.
Market Interest Rates
Without getting too deep into the weeds, think of market interest rates as the current rates paid on bank deposits, investments, and loans. It’s what you see and experience in the economy on a daily basis.
Now, there are a number of technical factors that cause market rates to rise and fall. You can’t do anything about them, so no need to go down that rabbit hole here.
What’s important is how these rates can affect the prices of your bonds. You see, not everyone holds on to their bonds for the 2,3, or 10 years stated in the bond agreement.
The economy can change, people may need cash urgently, etc. There are a plethora of reasons why someone might want to cash in their bonds sooner. So, there’s a huge bond buying and selling market to accommodate this process. And just like the stock market, there are investors who are constantly looking for bond deals and bargains.
So let’s examine how market rates can hurt or benefit you if you decide to sell your bonds before the maturity date. You’ll often hear about the bond and interest rates inverse relationship. Allow me to clarify using a couple of scenarios.
Scenario #1: When Market Interest Rates Rise, Bond Prices Will Fall
In our earlier example, the bond price was set at a face value of $5,000 and the assigned fixed interest rate was 4%. But if market rates start to increase, that will not be a be a good thing for your bond investment. Here’s why.
New bonds are constantly being issued. So if existing economic market rates bump up to 6%, then any newly issued bonds will likely have rates in that neighborhood.
So why would another investor want your fixed 4% bond if they can get a new one with a 6% interest rate? They won’t. The face value of your bond will remain unchanged, but you’ll have to sell it at discount or small loss if you want to unload it.
Scenario #2: When Market Interest Rates Fall, Bond Prices Will Rise
As you might expect, if market interest rates drop, then your bond will be in the catbird seat. No investor is going to want a new 2% bond if they can get yours for 4%.
In fact, because your bond will be in high demand, you should be able to make extra profit beyond what you would have gotten if you kept it until it matured.
Many investors tend to hold on to their bonds until they mature. But it’s important that you monitor market interest rates and understand how they are impacting your bonds.
That’s because if market rates cause the price of bonds like yours to fall in the overall marketplace, there could come a time when you may want to sell yours at perhaps a small loss and redirect that money into a much better investment with higher long term returns.
Conversely, you may wake up one day and discover that market interest rates are significantly lower than the coupon rates on your bonds. If so, that could represent and opportunity to sell yours at a premium.
In conclusion, if you know about interest rates and bond prices, and how they relate to one another, you’ll be in a position of strength when shaping your investment portfolio.
|Page 1||Page 2||Page 3||Page 4||Page 5||Page 6|