What you pay for a bond, and the amount you collect when you sell it, depends on when those transactions occur.
The only time a bond’s purchase price is predictable is at issue, when you pay par value — usually $1,000 — which is also the amount you expect to get back if you hold the bond to maturity. After issue, however, bonds trade at prices above and below par, in response to current interest rates, predictions about future rates, the specific credit risk involved, and shifts in investor demand.
When a bond trades at a price above par, it’s said to trade at a premium.
When a bond trades below par, it trades at a discount. In the shorthand of bond pricing, a bond at par value is said to be priced at 100. Figuring the dollar price of a bond is easy: Just multiply by 10. So a bond listed at 98.7 has a price of $987.
WHY PRICES MOVE
Change — or the expectation of a change — in the current interest rates exerts the strongest influence on bond prices. When interest rates rise, the prices of existing bonds drop. That’s because demand for existing bonds decreases when newer bonds that are paying higher rates attract more investors with their better yield.
Small changes in credit rating may lead an investor to demand small price changes. But if a bond drops out of investment grade, rises into investment grade, or rapidly jumps several ratings categories, investors could demand a larger shift in price.
Treasury bonds that have already been issued may also change in price to reflect market sentiment. For example, they may cost more and yield less when there’s uncertainty in the equity markets or as a result of political pressures. If sentiment changes, Treasurys could drop in price, providing a higher yield, or the opposite.
Unlike corporate and municipal bonds, which are priced in dollars and cents, Treasury prices are stated in 32nds, with 1/32 equal to 31.25 cents (0.3125). For example, if a note is quoted at 100:12, or 100 and 12/32 (3.75), the price is $1,003.75.
TRACING A TRADE
Stock prices are everywhere, crawling across tickers and being updated as soon as they change. Bond prices tend to be less transparent.
The vast majority of bonds trade over-the-counter — as private arrangements between individual dealers. Because of the one-on-one nature of the bond business, bond prices have been much harder to track. But that’s changing.
The FINRA Trade Reporting and Compliance Engine (TRACE) collects trading information on all OTC corporate bond transactions handled by member broker-dealers and makes the public data available free of charge in real time at www.finra.org/marketdata. This transparency makes it easier for investors to evaluate the prices that are being quoted to them for comparable trades.
The pricing of municipal bonds also became more transparent in 2005, when the Municipal Securities Rulemaking Board began offering free real-time pricing information on municipal bond trades. It’s available without charge at www.investinginbonds.com.
This website also provides extensive pricing and other information on US government and corporate bond markets as well as general information on mortgage-backed and asset-backed securities.
These new systems are a vast improvement over the former practice, when investors had to call several dealers to compare quotes, making it hard to determine a fair price.
EVERY DAY PAYS
Coupon payments usually come twice a year, but a bondholder technically earns interest every day. So when you buy a bond, on top of the price the dealer charges you, you pay accrued interest, which is interest that the previous owner earned since the last coupon payment.
MEET THE MARKUP
One way that bond pricing differs substantially from stock pricing is in the way dealers charge commissions. On a stock trade confirmation, you see the actual price of the stock and the price of the commission. In contrast, the bond price on a confirmation includes the commission, which is figured as a loosely regulated percentage of the bond’s price.
The difference between the price the dealer pays and the price you pay is the markup. Markups may be substantial — up to 4% or 5% for some bonds — which could be a whole year’s interest. The harder a bond is to sell, the higher the markup tends to be. If you’re buying or selling a bond with a lot of active trading, such as a Treasury security, the markup will be much lower than it would be with a high-yield corporate bond that trades infrequently. (Markups on Treasurys generally stay under 0.5%.) Also, if interest rates are rising, older bonds with lower rates become harder to sell, which means higher markups. Smaller trades also involve higher markups, which can greatly affect the bond’s yield. If the broker you buy from doesn’t have the bond in inventory, there may actually be two markups embedded in the bond price. That’s because the broker must buy the bond from another dealer, who charges a separate markup.
WHAT’S THE SPREAD?
One way to find the markup for a bond is by asking for its bid-ask spread. The bid is the price a buyer wants to pay, and the ask, or offer, is the price the seller wants.
For instance, a bond might have a market spread of 80 bid/83 ask, which is a spread of 3, or $30. The market spread is the spread for dealers — what they pay if they buy and sell. When you buy and sell, the spread will likely be wider. Commissions are negotiable, though. Brokers may be able to get you a better price — if you ask.