Trading Bonds

Fundamentals of Market Investing by Adam J. McKee

If you hold onto your bonds to maturity, you are guaranteed to get your money back as I described above.  You can also sell them early.  Bonds can be traded on the open market like stocks.  When you get into this game, the value of the bond can rise and fall just as stock prices do.  When bonds are traded in the market before maturity, then a number of great importance to the investor is yield.  The yield of a bond is the coupon amount divided by the price.  This gives us a ratio of interest to price.

It is important to keep in mind that the amount of the interest payment doesn’t change even if the value of the underlying bond does change.  Let’s go back to our earlier example:  Let’s say you invest in a bond with a face value of $1000 and a coupon of 10% and a maturity date ten years in the future.  What happens if the price drops to $800?  Then the yield shoots up to 12.5% ($100 / $800 = .125).  That sounds great!  However, what if bond prices go up and the underlying bond is worth $1200?  Then the yield falls to 8.33% ($100 / $1200 = .8333).

The most significant influence (but not the only) on what bond prices will do in the market is the prevailing interest rate.  When the Federal Reserve changes interest rates, the market listens.  When interest rates go higher, the prices of bonds in the market fall.  This raises the yield of the older bonds and brings them into line with newer bonds being issued at higher interest rates (coupons).  The converse is also true.  When interest rates are cut, the prices of bonds in the market goes up.  This causes a decline in the yield of the older bonds and brings them into line with newer bonds being issued at lower interest rates.

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