by Archie M. Richards, Jr., CFP^®
October 13, 2003

Bond prices are quirky. First, a general description:

Bonds are IOUs, issued by governments and corporations for money they're borrowing. On a specified date in the future, each bond pays off at $1000, called the "par value." (You can't buy just one bond; usually at least five are the minimum.)

Interest payments are paid semiannually. If a bond pays $50 a year ($25 every six months), that's 5 percent of the par value. This bond is said to have a "5 percent coupon."

The greater the chances of the loan defaulting, the higher the interest return. U.S. Treasurys are rated the most secure; their interest rates are the lowest.

All these elements - the $1000 par value, the date of maturity, and the timing and amounts of interest payments - remain unchanged throughout the bond's life. But interest rates in the economy change all the time. Something about the bond has to adjust.

It's the price that adjusts. You may be unaware of the price changes, because, unlike stocks, the current prices of most bonds are available only through bond dealers and not published every day. The United States has hundreds of thousands of bond issues, many of which trade infrequently. Providing up-to-date prices on all of them would be unnecessarily expensive.

The total return of a bond (called the "yield-to-maturity") takes into account all of the key elements: the par value, the time to maturity, the amounts and timing of interest payments, and the price.

If the price stands below the par value, the bond sells at a discount. At maturity, the profit between the discounted price and the par value adds to the yield-to-maturity.

If the price stands above the par value, the bond sells at a premium. At maturity, the loss reduces the yield-to-maturity.

Let's say that several years ago you bought bonds that have 6 percent coupons. You paid par ($1000 for each one), and you now want to sell them. Since your purchase, interest rates on bonds have fallen. Newly-issued bonds have 5 percent coupons, not 6.

Are you going to accept par value for your bonds? Heck no! To a potential buyer you'll say, "From new bonds of the same quality and maturity as mine, you'd receive interest of only 5 percent. My bonds pay 6. I therefore insist you pay me a premium. At maturity, the bonds will pay off at par. The loss will reduce your yield-to-maturity from 6 percent down to 5."

Actually, you don't say all that. But bond dealers take your point of view into account when they price your bonds. As the interest rates in the economy fall, bond prices rise. The drop in rates gives you a profit when you sell.

Let's go the other way. Again, the bonds you bought at par have 6 percent coupons. But the interest rate on bonds of the same quality and maturity has since risen to 7 percent.

Would the buyer be willing to pay you the par value? No, she'd be inclined to say, "For new bonds of the same quality and maturity, I'd receive interest of 7 percent. Your bonds pay only 6. I therefore insist you sell your bonds at a discount. At maturity, the profit I incur will increase my yield-to-maturity from 6 percent to 7."

There's no arguing; you have to sell at a loss. As interest rates rise, bond prices fall.

No matter whether interest rates go up or down, bond prices move in the opposite direction.

The longer the maturity of the bond, the greater the volatility of price. For a bond due tomorrow, changes in interest rates mean almost nothing, because payment of the $1000 par value in only one day is so imminent. But on a bond due in 30 years, the par value, payable so far in the future, means almost nothing today. But the current changes in interest rates have great impact. In general, interest rate changes affect long bonds more than they do short ones.

So much for quirky bond prices: As interest rates change, bond prices move opposite. The longer the time before maturity, the greater the price fluctuation.