bond market mechanics: how bonds trade after issuance

In short

A friend of mine once asked why her bond fund dropped when she had not sold a single thing. The answer sits in how bonds trade after the bank hands them out. A bond is a loan with a fixed payment, and its price moves as the world changes around that promise. When market rates rise, older bonds with lower payments are worth less to a buyer. When market rates fall, older bonds look better and sell for more. If you hold a bond to its maturity date and the borrower pays, you get your face value back. Selling early is where the price swings land on you. Knowing this ahead of time is a quiet comfort.

The whole of it

What it is

I once watched an old farmer sell a note he held on a neighbor's land. He did not wait for the neighbor to pay him off. He found a man in town who wanted the steady payments, and the two of them settled on a price. That is the whole idea behind the secondary market for bonds, which is simply the place where people trade bonds that already exist, once the first sale is done.

When a company or a government first sells a bond, that is called issuance. The borrower gets the money. The buyer gets a promise of regular interest payments and the face value back on a set date. The face value is also called par, and it is often $1,000 for a single corporate bond. The interest rate printed on the bond is the coupon rate. It stays fixed for the life of the bond.

After that first sale, the borrower steps back. The bond passes from one owner to the next. Still, the borrower owes the same payments to whoever holds the bond on payment day. What changes is the price people agree to pay for that stream of payments.

Most bond trading does not happen on a loud exchange floor. It happens over the counter, which means dealers and buyers deal with each other directly, often by computer, and a dealer is a firm that stands ready to buy or sell a bond from its own stock. Because of this, two investors can see slightly different prices for the same bond at the same moment. You have probably noticed the same thing when you compare prices on a used truck. Prices wander.

How it works

If you are holding a bond, here is the part that surprises people. The price and the yield move in opposite directions. Yield is the return a buyer earns at today's price. When the price goes up, the yield goes down, and when the price goes down, the yield goes up. Picture a seesaw. One end cannot rise unless the other falls.

Here is why. Say you own a bond paying a 3 percent coupon. Then market rates climb, and new bonds of the same quality pay 5 percent. Nobody will pay full price for your 3 percent bond when a 5 percent bond is for sale next door, so the price of your bond has to fall until a buyer earns about the same return as on the new ones. The coupon does not change. The price does the adjusting.

Rates falling works the other way around. If new bonds pay only 2 percent, your 3 percent bond looks generous, and buyers will pay more than face value for it. That extra amount is called a premium. When a bond sells for less than face value, it sells at a discount.

Two things decide how hard the price moves. The first is time left until maturity. A bond that matures in thirty years swings more than one that matures in two years. The second is the coupon size, because a bond with a small coupon swings more than one with a large coupon, since more of its value sits far out in the future. Bond people have a measure for this called duration, which gives a rough sense of how much a price moves when rates move one percentage point.

The borrower's health matters too. If investors start to doubt a company can repay, they demand a higher yield to hold its bonds. The price drops even if interest rates did not move. This is called credit risk. Rating agencies publish letter grades that try to describe it, though the grades are opinions, not guarantees.

One more piece. Bonds pay interest on set dates, so a sale usually falls between payment dates. The seller has earned part of the next payment but will not receive it. So the buyer pays the seller that earned slice on top of the price, and it is called accrued interest. It is listed separately on a trade confirmation.

The numbers, and where to find yours

Your own bond has a few numbers worth finding. The face value, the coupon rate, and the maturity date are printed on the bond or listed on your brokerage statement. For a corporate or municipal bond, the identifier is a nine character code called a CUSIP. Trade prices for many municipal bonds appear on EMMA, the free site run by the Municipal Securities Rulemaking Board. For corporate bonds, FINRA publishes trade prices through its TRACE system. For Treasury securities, the Treasury Department's TreasuryDirect site explains how they are sold and what they pay.

Be careful about one thing. Dealers earn their pay from the gap between what they pay and what they charge, called the spread. It is built into the price, so no separate fee may show up. Smaller trades often face wider spreads than large ones. Ask your broker to show the price and the spread before a trade is placed.

A worked example

Let me tell you about a woman named Dolores. She bought a bond with a face value of $1,000 and a coupon rate of 4 percent. The bond pays $1,000 times 0.04, which is $40 a year, and it matures in ten years. She paid $1,000 for it at issuance.

Two years later, market rates for similar bonds rose to 6 percent. Dolores needs cash and decides to sell. A buyer will want a return near 6 percent. With eight years left, the bond's $40 annual payment and its $1,000 final payment are worth less today than they were. Using standard present value math, the bond would trade near $876. Check it. Eight years of $40 payments discounted at 6 percent come to about $248, and the $1,000 at the end, discounted eight years at 6 percent, comes to about $627. Add $248 and $627 and you get $875, close to $876 after rounding.

So Dolores sells for about $876, which is $124 below what she paid. She also collected $40 times 2 years, or $80, in interest along the way. Her net result is a loss of about $44 on the $1,000 she put in. That is a real loss, and it came only because she sold early.

Now suppose a different Dolores holds on. She keeps collecting $40 a year for all ten years and gets $1,000 back at maturity, assuming the borrower pays. Her total interest over ten years is $40 times 10, which is $400. Same bond, same rate move, very different outcome. The price drop was a paper loss that she never had to take. Patience mattered, but so did whether she could afford to wait.

Where it goes wrong

I have seen smart people trip on this. The most common stumble is thinking a bond is safe in every way because it pays a fixed amount. The fixed payment is shielded from rate changes only if the owner holds to maturity. Sell early, and the price risk is the owner's.

Another stumble is ignoring how thin some markets are. A bond from a small issuer may trade rarely. When a seller wants out fast, the buyer may offer a low price, because few people are bidding. This is called liquidity risk, and it hits hardest in stressful times.

A third is forgetting that some bonds can be called. A callable bond lets the borrower repay early, usually when rates have dropped and refinancing is cheap. The holder gets the money back sooner than planned and must reinvest at lower rates. The bond's offering documents state the call dates and prices, so read them.

Watch for tax surprises too. Interest from most bonds is taxed as ordinary income. A gain from selling above the purchase price is taxed as a capital gain, and the rate depends on how long the owner held the bond. The IRS explains the rules in Publication 550, Investment Income and Expenses. A tax professional can tell you how it applies to your case.

Finally, a price you see online may not be a price you can get. Quotes can be stale. Confirm before you trust it.

Questions to answer before you leave this page

When you look at the bond you hold, do you know its face value, its coupon rate, and its maturity date? If you had to sell next month, could you afford to take whatever price the market offers, or would you want to wait until the borrower repays? Have you checked whether the bond can be called, and on what dates? Do you know how far the price might move if rates changed by one percentage point, and would that sit comfortably with you? Have you asked your broker what spread you are paying, and where the trade price was last reported on EMMA or TRACE? And finally, what would you do with the money if the bond were paid off early?