How bonds are issued and traded

In short

A friend of mine once asked me why her bond fund dropped when nobody had missed a single payment. You have probably wondered the same thing. A bond is a loan you make to a company or a government, and it is issued once, then traded many times. The interest rate on a bond is fixed when it is sold, but its price moves every day. When market rates rise, older bonds with lower rates sell for less. When market rates fall, they sell for more. If you hold a bond until it matures, you get the face amount back, as long as the borrower pays. Before you buy anything, look at the maturity date, the rate, and the price you would pay. Knowing those three things clears up most of the confusion.

The whole of it

What it is

I once watched my neighbor lend his brother two thousand dollars for a truck. They shook hands, and my neighbor said, "I will want it back in two years, with a little something for my trouble." That is a bond, only with a lot more paperwork.

When a company, a city, or a national government needs money, it can borrow from many people at once. It does this by selling bonds. Each bond is a written promise. The borrower, called the issuer, agrees to pay interest on a schedule and to return the original amount on a set date. That original amount is called the face value, or par. Many bonds carry a face value of 1,000 dollars, though this varies.

Three terms come up again and again. The coupon is the interest rate stated on the bond. The maturity is the date the issuer must repay the face value. The yield is the return you earn given the price you actually paid. You may see the coupon and yield disagree, and that is normal. It is the key to the whole subject.

How it works

You have probably heard that bonds are sold in two steps. The first step is the primary market. This is where the issuer sells new bonds for the first time. Big banks called underwriters often help. They buy the bonds from the issuer and sell them on to investors. The United States Treasury does it differently. It holds regular auctions, and you can bid in them through TreasuryDirect, a site run by the Treasury itself.

The second step is the secondary market. This is where bonds change hands after the first sale. Most of this happens between dealers and large investors, not on a loud trading floor. Dealers quote a price to buy and a price to sell. The gap between the two is how they get paid. It is a cost to you, so it is worth asking about.

Here is the part that trips people up. The coupon never changes, but the price does. Say a bond pays 4 percent, and then new bonds start paying 5 percent. Nobody wants your 4 percent bond at full price when a 5 percent one is on offer. So its price falls until the return on it matches the going rate. The reverse also holds. Prices and market rates move in opposite directions. Remember that one.

Two other things move prices. One is time. A bond with many years left reacts more to rate changes than one that is close to maturity. The other is trust. If people doubt an issuer can pay, they demand a higher return, and the price drops. Agencies such as Moody's and S&P Global Ratings grade issuers, and those grades are opinions, not guarantees.

The numbers, and where to find yours

You have a right to see the real figures before you act, and good news, they are public. For a Treasury bond, the Treasury posts auction results and rates on TreasuryDirect and on its own website. For a corporate or city bond, look up the bond by name on EMMA, the free site run by the Municipal Securities Rulemaking Board for city and state bonds. For company bonds, FINRA, the industry regulator, offers price data through its own tools. The Securities and Exchange Commission runs a site called Investor.gov, with plain guides on bonds. It also runs EDGAR, where companies file their official documents.

Some numbers are set by law or by the Treasury and change over time. The rate on a savings bond is one example. The current Series I bond rate is the current figure, which the official source publishes each year, and the yearly purchase limit is the current figure, which the official source publishes each year. Both are posted on TreasuryDirect. I will not guess at them here, because they change.

Your own numbers are simpler. Find the face value, the coupon rate, the maturity date, and the price quoted today. Your statement or the bond's page will show them.

A worked example

Let me tell you about a woman I will call Ruth. She lives in Ohio and had 5,000 dollars in savings she wanted to put to work for a few years.

She looked at a bond with a face value of 1,000 dollars and a coupon of 4 percent. Ruth wanted to know what she would be paid. She worked it out this way. The yearly interest is 1,000 dollars times 0.04, which equals 40 dollars per bond. If the bond pays twice a year, each payment is 40 divided by 2, which equals 20 dollars.

Now for the price. The day Ruth looked, market rates on similar bonds had risen to 5 percent. Her broker quoted the 4 percent bond at 980 dollars, not 1,000. She paid 980 dollars for a bond that would return 1,000 dollars at maturity. That extra 20 dollars is a gain she keeps if she holds to the end.

She checked her current yield, which is the yearly interest divided by the price. That is 40 divided by 980, which equals about 0.0408, or 4.08 percent. Her return over the full life of the bond is a bit higher, since she also gains the 20 dollars at the end. That fuller figure is called yield to maturity, and her broker's screen showed it.

Then Ruth asked the question a careful person asks. What if I need the money early? She learned that if rates rose again, her bond might sell for 950 dollars, and she would take a loss of 30 dollars per bond. If she held on, she would not feel that loss at all. Ruth chose bonds that matched the date she would need the money. Her father had told her that a promise kept on time beats a bargain sold in a hurry.

Where it goes wrong

I do not think anyone means to get caught out. But it happens, and it is nothing to be ashamed of.

The first trap is thinking a bond has a fixed value. It has a fixed promise, but the price can move. If you sell before maturity, you may get less than you paid, or more.

The second trap is ignoring cost. Dealers earn money on the gap between buy and sell prices, and some funds charge yearly fees. A small cost repeated for many years adds up. Ask what you would pay, and ask for it in dollars.

The third trap is trusting a rating too much. A high grade lowers the risk but never removes it. Issuers can miss payments, an event called default. Some bonds, called callable bonds, can also be paid off early by the issuer. That can cut your income short just when rates have fallen and you cannot find the same return elsewhere.

The fourth trap is forgetting inflation. If prices rise faster than your bond pays, your money buys less when you get it back. Tax matters too. Interest on city bonds is often free of federal income tax, while interest on company bonds is taxed. Rules differ, so check the IRS website, IRS.gov, or ask a tax professional about your own case.

Last, do not confuse a bond with a bond fund. A fund holds many bonds and has no single maturity date. Its price can fall and stay down. That is a different animal.

Questions to answer before you leave this page

What date do I need this money back, and does the bond mature near that date? What is the coupon, and what is the price I would actually pay today? What yield to maturity does the screen show, and did I work out the interest in dollars myself? Who is the issuer, and how do I feel about lending to them for that long? What would I do if the price dropped and I needed cash early? Is there a fee, a dealer markup, or a call feature that changes what I earn? Have I checked the numbers on TreasuryDirect, EMMA, or EDGAR rather than taking someone's word for it? And do I know how the interest will be taxed for me?