Today, we are looking at How to read a bonds quote. Corporate bonds are priced based on their face value and the current interest rate environment.
The bond market is one of, if not the largest securities markets in the world, representing over $100 trillion in assets.
Despite this, while most investors are familiar with stocks and real estate as investment vehicles, few are aware of the size and scope of the bond market or even what bonds are.
Simply put, a bond is a loan made to a bondholder by a bond issuer.
For example, if you buy a government bond, you are in fact lending money to the government.
Likewise, if you buy a corporate bond, you are lending money to the corporation that issued it.
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How Do Bonds Work?
A bond works similarly to a regular loan, in that a bond pays the bondholder interest (known as the coupon) and the principal is repaid at a given time (known as the maturity).
There are many different bonds, but the largest and most important one (after government bonds) is the corporate bond market.
The corporate bond market is a vital component of corporate performance, as it provides corporations with the ability to borrow money which can be used to fuel growth, fund acquisitions, and meet short-term cashflow challenges.
For example, imagine you run a company that manufactures medical supplies.
Demand from your customers increases and you are now seeking to expand your manufacturing capabilities by building a new manufacturing plant at a cost of $3 million.
To help pay for the plant, you decide to fund it by issuing a bond.
Investors buy the bond and in return, the company as the bond issuer has to pay the bondholders interest (the coupon) and repay their principal after an agreed period, such as 5 years.
Corporate bonds, like other bonds, provide investors with a number of useful characteristics such as a steady income, potential for capital appreciation or preservation as well as diversification.
By understanding a few key terms and how corporate bonds are calculated and quoted, you can incorporate these important and useful financial assets into your portfolio.
Reading a Corporate Bonds Quote
There are several key terms that are used to describe bonds.
Price
This is the price that investors are willing to buy or sell an existing bond and it is generally based on the future cash flows of the bond.
Depending on the current level of interest rates, the price of the bond can be at par, below par or above par.
Face Value
The face value of a bond is the amount of money that is paid to the bondholder when the bond reaches maturity.
This amount is not guaranteed as the bond issuer could default on the bond if they have insufficient cash flow or are unable to roll over the debt.
Maturity
A bond’s maturity is the date when interest payments cease and the bond is repaid to the bondholder (at face value).
The maturity date is used to classify the bonds into one of three main categories: short-term (one to three years), medium-term (10 or more years), and long-term (30 or more years).
Coupon Rate
The coupon rate is the rate of interest that a bond issuer will pay to the holder of the bond.
A common beginner mistake is that the coupon rate is based on the market price of the bond, when in fact it is based on the face value of the bond.
Since most people only care about the return they get after purchasing an investment, using the yield to maturity (see below) can help prevent any misunderstandings.
Yield to Maturity
The yield to maturity is a very widely used measure for the comparison of bonds.
It describes what the annual return is on the bond if you held it to maturity, taking into account what you paid for the bond and when you bought it.
Now that we know the key terms, we can explore how bond prices are quoted.
Using our previous example of raising $3 million worth of bonds to fund the construction of a new manufacturing facility, you decide that you will issue 3,000 bonds at a coupon rate of 4% and maturity of 10 years.
Since you need to raise 3,000 bonds, they will need to be priced at $1,000 each since:
3,000 x $1,000 = $3 million
The $1,000 price is known as the face value and is the amount that investors will need to pay to buy each bond.
Once in the secondary market (where investors can trade the bonds with one another), the price of the bond can change.
Bond prices are quoted as a percentage of the bond’s face value, such that a bond quote of 98 means that the bond price is $980 for every $1,000 of face value.
Similarly, a bond quote of 102 means that the bond price is $1,020 for every $1,000 of face value.
Bonds Quote at 100 = Par Value
When the bond is priced at 100, it means that it is trading ‘at par’, that is to say, it costs $1,000 for every $1,000 in face value.
When prices are quoted below 100 they are said to be ‘below par’ and when prices are above 100 they are said to be ‘above par’.
Prices of bonds change over time due to interest rates.
When interest rates rise, investors will be able to buy newer bonds that pay a higher interest rate compared to older bonds, so the bonds with lower interest tend to drop in price.
Likewise, when interest rates fall, older bonds will pay a higher interest than newer bonds so they will increase in price.
Conclusion
Corporate bonds are simply a loan made to a corporation, that provides interest payments (the coupon) and the return of principal at maturity.
Corporate bonds are priced based on their face value and the current interest rate environment.
Rising interest rates cause a decrease in the price of older bonds while falling rates increase the price of older bonds.
Bond prices are quoted as a percentage of face value, such that a quote of 98 means that the bond price is $980 for every $1,000.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
