Ask yourself if, when you loan money, you are content just having the actual loan amount returned to you. Probably not. You expect to be paid interest on your investment.
When you buy a bond, you loan money to the seller. Sellers fall into one of four groups:
1. US Government;
Sold by the Treasury Department, these bonds are referred to a ‘Treasuries.’
3. State & Local Governments;
4. Other Government Agencies
Example, Fannie Mae, the Federal National Mortgage Association.
Can we assume that all bonds pay the same rate of interest; that one bond is as good as another? No, we can not.
Bonds are sold with a specific Par Value, normally $1,000. Sellers promise to make interest payments at known time intervals. The rate of interest is known as the Coupon Rate and heralds back to the days when bonds had paper coupons attached that the buyer was required to present for payment. In addition, bonds are sold with a Maturity Date, the date at which the seller promises to buy back the bond for its Par Value.
Three factors: Par Value, Maturity Date, and Coupon Rate, must be known when comparing bonds.
Here’s an example of how the Coupon Rate plays a part in determining the initial price of a bond:
Two bonds are being sold with identical Par Values and identical Maturity Dates, but one bond carries a 5% Coupon Rate; the other pays 10%. Would you be willing to pay the same amount for each bond?
You expect to pay less for the bond that pays 5%. Less enough so that if you hold the bond to maturity, the total amount of all interest payments received, plus the Par Value of the bond itself, is, as a percentage of your investment, identical for both bonds.
Par Value of Each Bond: $1,000
Maturity Date: 5 Years from purchase
Bond 1: Coupon Rate 10% = $100 per year
Bond 2: Coupon Rate 5% = $50 per year
Interest Received: $100 x 5 years = $500
Par Value: $1,000
Total Received: $1,000 + $500 = $1,500
Interest Received: $50 x 5 years = $250
Par Value: $1,000
Total Received: $1,000 + $250 = $1,250
How much will you pay for each bond in order to receive the same Rate of Return on your initial investments?
Mathematically, this is how we will calculate the price of Bond 2, assuming we pay Par Value, or $1,000, for Bond 1.
$1,250 * ($1,000 / $1,500) =
$1,250 * (.667) =
We will pay $833.33 for Bond 2, the 5% Bond, versus $1,000 for Bond 1, the 10% Bond. At these respective prices, we will receive 10% on our investment regardless of which bond we buy.
Try this yourself with any two bonds. Assume different Maturity Dates and Coupon Rates.
What if the 5% Bond is a Treasury, guaranteed by the US Government? The 10% bond is being sold by a corporation with a track record of failing to meet its debt obligations.
Armed with these new facts, you should not be willing to pay the amounts we calculated above and receive identical Rates of Return. The 10% bond now carries greater RISK! There is a greater chance that the corporation will not meet all its interest payments or might default on the bond altogether.
The corporation knows that to entice you to make an investment in its bonds, it must compensate you for taking additional risk. Since the Coupon Rate is fixed at 5%, there is only one option. The bond must be sold at a discount, effectively increasing the interest rate you will be paid relative to your investment.
There’s no way for the corporation to know in advance what price you are willing to pay since it doesn’t know how much risk you’re willing to absorb. To help you gauge risk, companies like Moody’s and Standard & Poors assign risk ratings to bonds.
Using Treasury Bonds as the benchmark against which all other otherwise comparable investments are judged, you now know why and how bond prices can fluctuate.