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Bond Prices

The valuing of bonds is something that confuses most people who don't have a natural investment instinct. For example, say the current market interest rate is 10% and a company wants to issue $100,000 worth of bonds. They would issue 100 bonds, each with a face value of $1,000 and a coupon rate of 10%. The 10% coupon rate in this case means there is $100 interest paid each year on each $1,000 bond. When these bonds get issued their par value, by default, will be 100.

Then after these bonds trade in the open market their value will be quoted relative to their par value. This pricing system allows different bonds with different face values to be compared directly. When a bond is trading above par (above 100) it is selling at a "premium". When it is selling below par (below 100) it is selling at a "discount". Also, a "point" is equal to 1% of the bondís face value. Therefore, when a bond is "up two points" that could mean a bond went from 84 up to 86 or 110 up to 112.

Here is an example to illustrate how it works. Let's assume a corporation issues $100,000 worth of bonds (100 bonds at $1,000 each). After a few months the value of these bonds drops 20% - or 20 "points". The bonds will now be trading in the open market at 80, which means each bond can be bought at $800 instead of $1,000. If you bought one of these bonds at $800 you would be entitled to the annual coupon (interest) payment of $100. By dividing $100 into $800 we get 12.5%, which is the yield you will receive when you buy the bond. This is called the "current yield". As you can see, when a bond is first issued the "coupon rate" is equal to the "current yield". After the bonds are issued, their values (and therefore their yields) change constantly with the market.

As you can see in the example above when the price of the bonds went down the yield went up. That is because bond yields and prices move inverse to one another. For example, if you read the business news and they talk about how the bond market has risen considerably over the past few months which means that interest rates have fallen during that time. If you learn nothing else about bonds just learn that one lesson - bond yields and bond prices move opposite of each other.

You can see how these relationships work in the real-world by looking at the chart below which was taken from the Bloomberg Bond Quotes page on August 19, 2007. If you look at the 10-year bond you will see it has a coupon rate of 4.75% and the last price it traded at was "100-16". This means the price is 100 and 16/32nds (when it comes to bond quotes, only Treasury securities still quote prices using 32nds of a dollar. All other bonds are quoted in decimal prices). Since the bond is trading a little above par this would indicate that the yield should be a little below the coupon rate of 4.75%. This is confirmed by looking at the current yield, which is listed at 4.69%.

You will also see confirmation that bond prices and yields moving inverse to each other. Where there is a decline in price (noted in red) there is a rise in yield (noted in green), and vice versa. You can also infer the issue date of the bonds by looking at the maturity date. If you look at the 30-year bonds and notice the maturity date of 05/15/2037 you can infer the issue date as 05/15/2007.


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