Bonds help add diversity to your portfolio and control risk. But they can be complicated. Learning about how to buy and sell a bond is just as important as why to buy or sell a bond. These two things are linked. We can help you understand the basics of buying and selling bonds and make them work for you.
How bonds are priced
A bond’s face value, or par value, is the price set by the issuing company or governmental agency and is how much the bond will pay when it is redeemed.
Most bonds are sold at either a discount or a premium to its face value. Except for savings bonds, the market will ultimately determine the selling price. Discount bonds sell for less than face value, or par value. A premium bond's selling price usually exceeds its par value.
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Bond prices move in the opposite direction of interest rates
Sometimes bonds are issued at a discount in an effort to attract buyers. After a bond is issued, it can be traded in the secondary market. The bond's price fluctuates depending on supply and demand, changes in interest rates and any downgrade of the issuer that could impact its ability to honor the terms of the bond. But most discounts develop mainly as a result of changes in interest rates.
Bond prices share an inverse relationship with interest rates. That means when interest rates rise, bond prices fall and when interest rates fall, bond prices rise.
To understand how that happens, start with a hypothetical 30-year corporate bond with a $1,000 face value issued 20 years ago with a 5% coupon interest rate. That means it has been paying $50 a year (5% of $1,000) for the past 20 years and is now ten years away from maturity.
You wouldn't give the owner $1,000 for that bond today because rates have risen since then, and you expect to earn more than $50 for each $1,000 you invest in bonds now. At what price would that 5% bond become a good buy? Finding out takes some math, but not much.
First, compare the current yield
The current yield is the annual interest payment divided by the current price. To put it another way, the current price is the annual payment divided by the current yield. Let's assume that other bonds you could buy are yielding 6.9%. The bond you're considering buying must match that or you should pass it up. What price for the $1,000 bond would make it yield 6.9% to the buyer? Here's the math: Price = 50/0.069 = $725 (rounded off). So $725 would be a fair price for this bond.
Next, find the yield to maturity
The 5% bond pays $50 a year and will be redeemed in ten years at its par value of $1,000, which is $275 more than the current price suggested by current interest rates. You won't realize the $275 for ten years, but for mathematical convenience let's say you receive the discount as equal installments of $28 for each of the ten years. The percentage figure that tells you how much you are earning from interest payments plus the annual payout of a tenth of the discount is the yield to maturity.
Unfortunately, you don't simply add and then divide. Bond dealers use bond tables and programmed calculators to compute yields to maturity, and some handheld financial calculators can do it. But you can approximate the yield to maturity with the following shortcut formula: annual interest + annually accumulated discount/ average of par value and current price x 100
For the bond in the example: 50 + 28 = 78/860 = .09069 x 100 = 9.06% = 9.1%
The same formula can be used for bonds for which you pay a premium. In those cases you would subtract the annually accumulated premium from the annual interest payment.
Don't worry about following this exercise too closely. It's presented not as a mathematical model for you to use, but as an example of the kinds of considerations that affect the value of a bond you might buy or sell at a discount.
Three things to consider:
Stay up to date on the credit rating. Many bonds have been on the market for a long time, so it's important to check current ratings. A bond's quality rating can be revised after it is issued due to a change in the issuer's financial health or market conditions. Confirming the financial health of the companies you've invested in is a wise way to monitor the stability of your portfolio.
Be sure there's an easy exit. Although you may buy a bond intending to hold it to maturity, you may need to cash it earlier than you planned. Marketability and liquidity are important factors to consider. Ordinary investors may want to limit themselves to investment-grade bonds that can be easily priced and sold to other investors. Having an exit strategy for hard times can help you to always get the most from your investments.
Watch your maturities. Often you can select bonds and time their maturity to when you need the funds for anticipated expenses, such as college tuition, retirement, or a planned reinvestment. Some investments will automatically cash you out and others require an affirmative step to redeem your bonds.
Have a plan for where the money goes next. If you have three months or more, you can consider a short-term investment, such as a certificate of deposit (CD) or a high-yield savings account, to earn a bit more interest while keeping the principal safe. Otherwise, be ready with a reinvestment strategy to get that money earning again.
Bottom line
Bonds seem simple until you start talking about interest payments, current yields and yields to maturity. While these can be daunting concepts, you should know the terms and how those concepts impact the underlying value of your bond. Knowing what you own and its worth can help you gauge how well your investments are doing now and plan better for future investing.