This is part two of a series on the bond market. It will cover the primary market vs. the secondary market, basic vocabulary, and how the bond market works. Click here for part one.
For investors who haven’t spent a lot of time studying the bond market, it can seem a bit complicated. There is new vocabulary to learn, and the trading process is different than the process for trading stocks. However, once you have a basic understanding of the vocabulary and how the market works, you can dive deeper to understand how trades are actually conducted.
Primary and secondary market
As we discussed in the first article in this series, bonds are a sort of loan. Sometimes companies or governments may issue bonds rather than take out a more traditional loan. Each bond is rather like a tiny loan taken out with investors. The issuer sets specific details with each new issue, and those details govern the life of the bond.
When you buy bonds on the primary market, it means you’re buying directly from the issuer, and you’re purchasing bonds that haven’t previously been offered to the general public. When you buy bonds on the secondary market, you are buying bonds that have already been bought and sold publicly. Here’s how each of these transactions work.
In the case of the primary market, bond sales are facilitated by investment banks which serve as underwriters. They set an initial price range and oversee the sale of the bonds to investors. Broker-dealers oversee sales of bonds on the secondary market.
Almost all of the bond trading activity that takes place every day in the U.S. is done between institutional investors and broker-dealers over the counter, unlike stocks, which are generally traded via exchanges. Bonds are largely traded over the counter because of their complexity. The same company can issue multiple bonds with different coupon rates, interest rates, yields and maturities. The credit ratings of the entities which issue the bonds also differs, which makes trading bonds even more complex.
Whenever a bond is first issued on the primary market, its price and its face value are the same. The face value, also known as the par value, is the amount of the loan’s principal, which must be paid back to the investor who bought the bond. After the initial sale, bonds are then traded on the secondary market, where prices fluctuate depending on what’s happening with interest rates, the issuer, or other factors.
Bond valuation
Three main factors which affect the price of a bond are the issuer’s credit rating, market demand for it, and the length of time that’s left before it matures. If the maturity date is very close, then the price will usually adjust closer to the par value. The coupon rate, which is the interest rate the issuer pays to the holder, is also a factor, as is the yield. The price of the bond can be at a premium or above par value or at a discount, or below par value.
The fair value of a bond is estimated to be the current value of the cash flow it is expected to generate. This means a bond’s value is calculated by discounting the expected cash flows to the current date using the correct discount rate. The discount rate that’s used varies from bond to bond, but it’s generally determined by looking at similar instruments if there are any. The valuation of a bond becomes even more complicated when there are options embedded.
In the case of a “straight bond,” which means any bond that has no embedded options, the valuation is done doing either relative pricing or arbitrage-free pricing. The relative pricing approach involves comparing the price of the bond to a benchmark, which is usually a Treasury or other government bond. This is the most common approach to determining what bonds are worth.
This is where the credit spread comes in. The benchmark that’s used to compare to the other bond is generally a bond issued by an entity with the best credit quality, which is why Treasuries with similar maturities are often used as benchmarks. The credit spread is the difference in yield between the bond you’re trying to value and the benchmark instrument.
For example, let’s say the 10-year Treasury is trading at a 6% yield, while a corporate bond maturing in 10 years is trading at a yield of 9%. The corporate bond has a credit spread of 300 basis points from the Treasury. Every 1 percentage point is equal to 100 basis points. Better-quality bonds have smaller credit spreads with the yield to maturity of their benchmarks. Higher yields generally mean more risk, which is why corporate bonds have higher yields than government bonds.
Yield versus price and coupon rate
Whenever you’re dealing with bonds, you have several percentages to consider when valuing them. The coupon rate is the coupon payment as a percentage of the face value of the bond. On the other hand, the current yield is the coupon payment as a percentage of the bond’s current price. Here’s how these terms refer to each other. The yield to maturity is the discount rate which affects the bond, so it’s a key factor when determining valuation.
When a particular bond is selling at a discount, the yield to maturity is greater than the current yield, which is greater than the coupon yield. However, when a bond is selling at a premium, the coupon yield is the greatest number, followed by the current yield and the yield to maturity. When a bond is selling at part value, all three of these values are the same.
All bond prices are affected by changes in the interest rate, but each bond’s sensitivity to those changes may differ. The duration is a measurement of how a bond’s price will change in response to adjustments to interest rates. In the case of smaller changes in interest rates, the duration will be roughly the percentage the bond’s value will fall by for a 1% per annum increase in the interest rate. Thus, the market price of a bond with 17 years left on it and a duration of 7 will decline approximately 7% if the market interest rate rises by 1% per annum.
The next article in this series will discuss even more aspects of the bond market.