Bonds are more than just loans to the Government and corporations they are often transferable securities that are traded through auctions, or through broker assisted deals. A bond can either trade at face value, at a premium, or at a discount or below face value. Bonds typically pay interest rates between 1-7% depending on the type of bond and these bonds can be traded on exchanges at different prices than their face value after original purchase.
I: Market making, interest rates and bond grading
Since many bonds are transferable, buyers and sellers of the bonds bid and ask for different prices. When a significant of these prices are satisfied, the price of the bonds either moves up or down. The exchange of bonds is managed through a market maker system in which the prices organizations and investors enter are tallied and arranged through a computerized system. If there are more buy requests satisfied these can have the affect of pushing prices upward and vice versa. As market conditions continue to change, the price of the bond is re-negotiated through the exchange system.
Other conditions affecting bond price include either corporate or Governmental adjustments to interest rates. For example, over time, an variable rate inflation bond may change by 1-2% to adjust for inflation. Also, the demand for higher paying yield bonds may be high causing a decrease in the value of bonds with lower interest rates. Another factor that can influence a bond price is a corporate bond downgrade. If a bond watchdog such as Standard & Poors determines a company’s credibility has declined, the bond grade of their bonds usually decline. These price drivers are summarized below:
* Market Making and Market activity: Trading on exchange is managed by a market maker and as prices investors are willing to pay or sell at change so to do bond prices.
* Interest Rate Adjustments: When the Government or corporations adjust their interest rates, changes in the price of pre-existing bonds occur.
* Bond Grade Down or Upgrade: If a Government or Corporation’s credibility declines, often the bond quality also declines potentially affecting price.
An example of an interest rate driven bond price change is given as follows to illustrate features of the bond pricing mechanism. During the course of exchange in bond markets the U.S. Treasury or other Foreign Treasury may adjust the treasury yield which directly affects interest rates. If the new rate is lower than the old rate, old Bonds will increase in value because they have better interest payments. For example, assuming an exact market adjustment to new interest rates, a 30 year Bond with a fixed rate of 4.5% valued at $1000.00 with 25, $45.00 interest payments remaining on Monday, will be valued at $1,164 on Tuesday because new rates are now 3.5%.
II: What to look for when purchasing bonds
As we have seen, bonds trade after they have been issued and the Treasury changes interest rates. This causes the price of the bonds to fluctuate. When actively traded in markets, prices can change further. Predicting these changes before they occur can mean the difference between predicting a price movement and not predicting a price movement. Some helpful indicators of potential price movement in bonds are as follows:
* Gross Domestic Product (GDP) Trends: If an economy is stumbling or slowing via slowing GDP, bonds may become more attractive to investors seeking more stable returns. This can cause an increase in the demand for bonds and consequently a rise in prices.
* Inflation Statistics: Inflation values such as the Core price index(CPI) and producer price index (PPI) can mean an impending drop in interest rates. If Bond rates decline, the value of old bonds rise.
* Liquidity Shifts: Big money moves and flows in and out of various markets. By tracking the flow of this money one can also track underlying demands and supply. These changes in supply and demand can affect bond prices.