How does trading bonds work?
Like stocks, corporate bonds can be bought and sold, so you can buy in late or get out before the bond hits maturity. There’s a lively secondary market to trade bonds, and there’s money to be made, and lost as well, doing it.
Because the price of a bond can change, the coupon rate stops being a useful measurement of its value. Instead, you’ll see the yield quoted, which is the annual coupon payment divided by the market value of the bond expressed as a percentage. You might also see YTM, or “yield to maturity” quoted: that measures what the estimated return of the bond is if you hold onto it until maturity.
The coupon payments of a bond are set in stone 🗿 when the bond is issued, which means that yield moves inversely to price.
For example, a £100 bond pays £5 a year, so its yield is 5%. If the price of the bond goes up to £110, its yield decreases to 4.5% (5 / 110). On the other hand, if the price drops to £90, the yield goes up to 5.6% – the coupon payment is now a greater proportion of the bond’s value.
What affects bond prices?
Like everything, prices are set by good old supply and demand. More specifically, corporate bonds will move when other investments – like (generally safer) government bonds – start to offer a better return.
If the US central bank decides to bump the general interest rate up to 2%, all bonds paying less than that are suddenly a whole lot less valuable – so their prices will fall, at least until the yield rises enough to outstrip the standard 2%. Prices also fall when inflation increases because future payments become less valuable and when the perceived risk of defaulting increases – but more on that in the next chapter.
As the maturity comes…
Bond price will typically revert to its par value as the maturity ⌛ date approaches, because there’s more certainty that the face value will be repaid and this becomes an increasingly large proportion of the return the investor will receive.
They also tend to increase when the stock market is experiencing turbulence 🌊 as investors look for the stability and safety offered by bonds. However, higher-risk bonds might not see the same inflow of funds during turbulent times.
As for risk, there’s a whole industry built around calculating a bond’s creditworthiness. Don’t be Moody: in chapter three let’s take a look at rating agencies.