Bond basics (very basic)

September 16, 2008 at 5:43 am | Posted in credit | Leave a comment
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Just a quick rundown on how bond prices work – Why bond prices fall when interest rates rise.

Assume that you could buy a bond for $1000, which pays a 5% a year interest – called a coupon, issued by some company X to help it raise money for expansion. You can expect to receive $50 a year on this bond; lets ignore the $1000 returned to you at the end of the term, as it doesn’t matter. Lets call this set of bonds Series A.

Why 5%? Well, assume you can lend to the US government at 4%, and there is no risk the US government will default. Company X could go bankrupt, so there is a small chance you could not only lose the $50 coupon, but also your $1000 principal. You wouldn’t lend to X at 4%, but, if X is willing to pay a high enough interest, above the US treasury, you may be willing to take the chance. The difference between what X has to pay and what the US government has to pay is the credit spread, and is expressed in basis points. 100bp = 1%, so in this instance, we could say the spread is 100bp.

Lets assume that, a year after we bought this bond, the same company is building a new plant and needs to borrow again. However, the economy isn’t doing so well, and investors are worried that the new plant may not have enough work – so the risk is higher. New investors therefore want a coupon of 6% on bonds which are identical to the ones from last year, because they think the risks have gone up. Lets call these series B, but lets assume that everything else remains the same -these bonds are going to get the same treatment by X. If the company went bankrupt, series A and B bonds get paid together, neither has priority over the other.

If the risk free rate is still 4%, then basically, the spread has widened from 100bp to 200bp because investors are more cautious about company X’s prospects.

If I had invested in the first bond (series A), my $1000 is going to bring in $50 this year, while a series B bond will bring me $60. Why not sell my series A bond, and buy a series B bond with the money? Thankfully, there is a bond market where I can sell a series A bond, and buy a series B bond. If I had put my money in a bank CD, I would be out of luck – The cost of redeeming a CD to open a new CD would probably be too high to make it worthwhile.

Anyway, if I and others like me sold our A bonds to buy B bonds, the price of A bonds would fall because there wouldn’t be too many buyers – why pay $1000 to receive $50 interest, when you can get a series B bond that receives $60? At the same time, the demand for series B bonds would push the price up.

If the price of the series A bond fell to $909, the $50 coupon (5% of the $1000 face value of the bond) would yield 5.5%. In the meantime, buying the series B bond for the $60 coupon would push the price up. At a price of $1091, the $60 coupon (6% of the $1000 face value) would also yield 5.5%.

Of course, this is pretty simplistic – even in our two bond world, there are many other factors why the yield on the two bonds would not be the midpoint of the two coupons. But, the two yields would be very similar, with the price of one rising while the other falls, to bring the yields close. Obviously, in real life, there are differences because of different maturity, and the large number of alternative bond investment options (each with a different coupon, credit spread to risk free treasuries – i.e. credit / default risk and maturity) increases the complexity.

But the basic idea remains – when a) the risk free rate increases, b) Macro economic concerns cause all spreads to treasury to increase (widen) or c) the bond investment looks riskier (say a new competitor is winning a lot of share, for e.g.), the price of the bond falls, and the yield increases.

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