bonds in plain words: the secondary market and pricing

In short

A friend of mine once asked why her bond was worth less on the day she checked than on the day she bought it. If you are holding a bond, you may have wondered the same thing. A bond is a loan, and loans can be bought and sold between people after the first sale. The price they trade at moves with interest rates. When rates rise, older bonds with lower payments tend to get cheaper. When rates fall, they tend to get pricier. If you hold a bond to its end date, the borrower owes you the face value no matter what the price did in between. A statement shows the coupon and end date, and a price quote shows what the bond trades for today.

The whole of it

What it is

I once watched my uncle sell a used tractor to a neighbor, and the whole thing took ten minutes on a gravel drive. Nobody checked with the factory first. The tractor changed hands because two people agreed on a price. A bond works much the same way after its first sale.

When a company or a government wants to borrow money, it sells bonds. That first sale is called the primary market. The buyer hands over cash. The borrower promises to pay interest on a set schedule and to return the face value on a set date. The face value is also called par, and it is often $1,000 for a single bond.

The secondary market is where those bonds change hands afterward. The borrower is not part of these trades. The money goes from one investor to another. A seller who wants cash before the end date can find a buyer there. A buyer who wants an older bond can find a seller.

Why does the price move? Because the interest payment on an older bond is fixed. It was set on the day the bond was first sold. The world keeps changing, though, and new bonds are sold at new rates.

How it works

A neighbor of mine keeps bees, and he says the price of honey follows what the market will bear that week. Bonds follow the same plain rule. A bond is worth what a buyer will pay for it.

Take a bond that pays $50 a year on a $1,000 face value. That is a 5 percent coupon, which is just the yearly interest payment shown as a percent of face value. Now suppose new bonds of the same quality start paying $60 a year per $1,000. Nobody wants to pay full price for the older bond that pays only $50. So its price falls until the buyer gets a fair deal.

The reverse also holds. If new bonds pay only $40 a year, the older bond with its $50 looks good. Its price rises above $1,000.

Two ideas help here. The first is yield, which is the return a buyer earns at the price paid. If you pay less than face value, your yield is higher than the coupon. If you pay more, your yield is lower. The second is called duration, a measure of how sensitive a bond price is to a change in rates. A bond with a longer time left tends to swing more than one that ends soon. That is because a buyer is locked into the old payment for more years.

Prices are quoted as a percent of par. A quote of 98 means $980 for a $1,000 bond. A quote of 103 means $1,030. A buyer also pays accrued interest. That is the interest earned since the last payment date, which the buyer owes the seller, because the seller held the bond for part of that period.

The numbers, and where to find yours

You have probably seen a number on a statement and wondered where it came from. Your bond's coupon rate, face value, and end date are printed on your trade confirmation and in your account. Those are the fixed pieces. The market price is the moving piece.

For tax matters, one limit matters to many bond owners. The yearly cap on capital losses you can use against ordinary income is the current figure, which the official source publishes each year. The IRS explains this in Publication 550, Investment Income and Expenses. The rate on long term gains depends on your income, and the current brackets are the current figure, which the official source publishes each year. Interest from most bonds is taxed as ordinary income, and the IRS covers this in the same publication.

For prices, FINRA runs a free tool called Market Data that shows recent trades in corporate and agency bonds. For Treasury securities, TreasuryDirect, run by the U.S. Treasury, explains how they are sold and what they pay. Look up your own bond by its CUSIP, a nine character code printed on your confirmation.

A worked example

A woman named Ruth bought a $1,000 bond when it was first sold. It paid a 5 percent coupon, which is 5 percent of $1,000, or $50 a year. It had ten years left.

Two years later, new bonds of the same quality paid 6 percent. A new $1,000 bond paid $60 a year. Ruth needed cash for a roof repair and decided to sell. A buyer looked at her bond and asked what price made it worth owning.

The buyer saw that Ruth's bond paid $10 a year less than a new one. That is $60 minus $50. Over the eight years left, the gap adds up to $80, found by 8 years at $10 a year. The market does a more careful version of this math, but the idea is the same. The price had to drop to make up for the smaller payments.

Say the bond sold at a quote of 94, which is $940. Ruth got $940 instead of $1,000. She took a $60 loss against her original cost, found by $1,000 minus $940. She also kept the interest she had already been paid.

Now look at the buyer. The buyer paid $940, will collect $50 a year, and will get $1,000 back at the end. That is a gain of $60 at the end, plus the yearly $50 payments. The buyer's yield is higher than 5 percent because of the discount.

Here is the part Ruth found comforting. Had she kept the bond, the borrower would still have owed her the full $1,000 at the end, as long as the borrower stayed able to pay. The $940 price was only a snapshot. It mattered because she chose to sell on that day. Her patience was never the problem. Her need for a roof was.

Where it goes wrong

I have made my share of mistakes with money, and most came from not asking one more question. A few traps are worth knowing about.

The first is believing the price drop is a permanent loss. It is only a loss if the owner sells. A bond held to its end date pays face value back, unless the borrower defaults. Default means the borrower fails to pay as promised, and that risk is real, especially with weaker companies.

The second is forgetting about the spread. That is the gap between the price a dealer pays and the price a dealer charges. Small trades in less active bonds can carry wide spreads. A buyer or seller may pay more than expected without any fee line on the statement.

The third is thin trading. Some bonds rarely change hands. A seller who needs cash fast may have to take a poor price. The word for this is liquidity, meaning how easily something turns into cash at a fair price.

The fourth is a call feature. Some bonds let the borrower repay early. The borrower is the one who decides, and a borrower has a reason to repay early when rates have fallen. The owner then loses the higher coupon.

The fifth is taxes. A bond bought at a discount can create taxable income in ways that catch some owners off guard. The IRS explains market discount and original issue discount in Publication 550. A tax professional can explain how those rules apply to a particular case.

Questions to answer before you leave this page

If you sold your bond today, would you know what price it would fetch, and where would you look that up? Do you know its coupon, its face value, and its end date? Could you say whether it can be called early, and by whom? If rates rose another point next year, how much time would you have left, and would that matter to you? Do you need this money soon, or can it sit until the end date? What would a sale cost you in spread and in taxes? And have you read what your own confirmation says about all of this?