How do bonds work in terms of prices? Most bonds are issued at a price of 100 which is referred to as par. Corporate bonds and Treasury notes/bonds are usually sold in increments of $1,000, and municipal bonds are sold in increments of $5,000. The value of a bond is calculated by taking the current price divided by 100 and then multiplied by the number of bonds you own. Bonds are sold in the primary market (when first sold to retail and institutional investors) such that the coupon (interest rate) is equal to the current interest rate prevailing in the marketplace at that time (sold at par which is 100). Bonds can be bought and sold after that issue date though. If interest rates rise or fall after issuance, how does the price of a bond adjust? If interest rates go up, bond prices will go down. If interest rates go down, bond prices will go up. Why? It is referred to as an inverse relationship. Think about it this way. If you own a bond that has a 6% coupon and interest rates rise to 8%, will you be able to see that bond to other investors? The answer is no if you decide to hold firm to a price of 100. Why should another bond investor buy a 6% bond when he/she can just buy a bond with very similar characteristics as yours and earn 8%? The only way that you can sell your bond is to lower the price such that the bond investor will earn 8% over the course of that bond’s life until maturity which is when the company or other entity has to pay the money back in full). Luckily for you, the process works in reverse as well though. If interest rates go down to 4%, you have the advantage. If you hold a bond with a 6% coupon as in the aforementioned example, bond investors will pay more than 100 in order to get that higher interest payment. How much more? Bond investors will bid the price up until the bond earns an equivalent of 4% until maturity. Why is this important to you as an investor today?
Let’s take a quick look at history. Most financial professionals are not old enough to remember or have been in business long enough to remember the interest rate environment back in the early 1980s. In the early 1980s, interest rates on bonds were incredibly high compared to today. The economy was stuck in a rut of higher inflation and low or no growth which was called “stagflation”. How high were interest rates? The interest rate on a 3-month Treasury bill was 16.3% back in May 1981, and the prime rate topped out around 20.5% soon after. For more information on the interest rates of this time period, please refer to this link: http://www.mbaa.org/ResearchandForecasts/MarketEnvironment/TreasuryYields&BankRates,1980-83.htm. The Federal Reserve chairman back then, Paul Volcker (Fed chairman prior to Alan Greenspan and the same gentleman as the so-called “Volcker rule” of today), instituted a monetary policy based upon the teachings of the famous economist, Milton Friedman, from the University of Chicago. Friedman was really the start of monetarism. Monetarism is simply the effect of the money supply in any economy on interest rates. In general, as more money in the economy is available, interest rates will go down. As less money is available, interest rates will go up. Why? Think about it in this manner. If you have to get a loan from a family member and you are the only person asking for a loan, chances are your interest rate will be lower than if that same family member is asked by 15 different individuals. So the Fed of that time period began buying all types of bonds on the open market. The hope was that, as the money supply grew, interest rates would fall. As interest rates fell, it would give more incentive to companies to take out loans to buy equipment and build plants and also to incent consumers to take out mortgages and buy homes or purchase consumer goods with credit cards. Needless to say, the policy eventually worked. It started what most refer to as the great bull market in bonds in roughly 1982.
There are only two ways you can make money when you own a normal bond. First, you earn money from the coupon paid over the life of the bond. Second, in a falling interest rate environment, you earn money by selling your bonds at a higher price. Therefore, you can earn money from interest and capital gains. In a rising interest rate environment, you can only earn money from the coupon. What individual investors, and some money managers even, fail to realize is this simple fact of finance. The yield on a 3-month US Treasury bill today is roughly 0.06%. No, that is not a misprint! The yield on these bills has gone down over 16% over the past 30 years or so. The bond market has never seen such an extended period of falling interest rates. Now interest rates did not fall in a straight line, but the trend has been toward lower interest rates for decades now. That anomalous occurrence is coming (has come) to an end.