Elementary Bond Question

[LaxFan]

I understand that bond price/rates move in opposite directions. I've bought zero-coupon T-bills and held until maturity (i.e. 4.4% for a couple weeks/month). Simple.

You often hear about how someone could get a certain rate on the 2, 5, 10yr, or other types of bonds.

So, let's say I buy a bond that matures in 10 yrs. Of course I want the price to go up to make a profit (good). But then the interest rate goes down (bad). Do I receive less interest?

I hear commentators get excited when the rate goes up (i.e. "you can get 5% risk free!") If the rate goes up I get more interest (great), but the principal declines. I know I'm missing something..

So what do I want to happen if I buy a bond (and don't hold to maturity)?

 

[Robert Morse]

LaxFan- A zero coupon bond is bought at a discount to par, like a T-bill. If you hold that to maturity, you have locked in a discount interest rate. Before it settles, it can change in price. It does not change your yield if held to maturity. It only changes your yield if sold early.

 

[LaxFan]

LaxFan- A zero coupon bond is bought at a discount to par, like a T-bill. If you hold that to maturity, you have locked in a discount interest rate. Before it settles, it can change in price. It does not change your yield if held to maturity. It only changes your yield if sold early.

Yes, I've got that part. It's the others I'm confused about.

 

[Real Money]

Bonds pay a fixed coupon which is divided by the spot price to imply a yield. As the bond trades at new prices, the yield floats. You are asking about something called the "total return" which is the mark to market of the bond with cash flows. Some of the funds are also holding cash, so the ETF price will reflect that as well.

Not a pro, just a student of the markets.

 

[Robert Morse]

What I said does not change if the maturity is 20 weeks or 20 years.

Yes, I've got that part. It's the others I'm confused about.

 

[BMK]

So, let's say I buy a bond that matures in 10 yrs. Of course I want the price to go up to make a profit (good). But then the interest rate goes down (bad). Do I receive less interest?

I hear commentators get excited when the rate goes up (i.e. "you can get 5% risk free!") If the rate goes up I get more interest (great), but the principal declines. I know I'm missing something..

Yes, you are missing something...

The interest rate on the bond you bought does not change--unless it is a floating rate instrument, which is a totally different conversation. Most bonds have a fixed interest rate. The interest does not change over the life of the bond, and it does not matter whether it is expressed as a percentage or a dollar amount. If you buy a $1000 bond with an interest rate of 4.00% and it pays twice a year, then you will get a check twice a year for $20.00.

And you will get a check for $1000 at maturity.

It really is that simple.

Except that you did not pay $1000 for that bond. You either paid more or less, depending on what the prevailing interest rates were at the time you bought the bond (i.e., what interest rate is available on newly issued bonds with the same amount of time to maturity, from a company with the same credit rating).

Over the life of the bond, the market price will rise and fall. If you bought the bond on Monday for $1063, by Friday that same bond could be trading at $971. Or it could be trading at $1092.

But that does not mean that "the principal declines." The face value of the bond is still $1000, and that is what you will get if you wait until maturity. It is the market price that goes up and down.

The other thing that may be confusing you is the yield.

Your yield is based on certain assumptions, e.g., that you are going to hold the bond until maturity, and that it will not be called early (i.e., paid off early), and that the issuer does not go into bankruptcy.

Your yield is a function of the price you paid for the bond and the interest rate. After you purchase the bond, the price you paid is never going to change, and the interest rate is never going to change. So your yield will not change.

But when you look up the current price of the bond, say, a week after you bought it, or a month after you bought, it will show a different yield because the platform is calculating the yield based on the current market price--not the price you paid when you bought it.

BMK

 

[LaxFan]

Yes, you are missing something...

The interest rate on the bond you bought does not change--unless it is a floating rate instrument, which is a totally different conversation. Most bonds have fixed interest rate. The interest does not change over the life of the bond, and it does not matter whether it is expressed as a percentage or a dollar amount. If you buy a $1000 bond with an interest rate of 4.00% and it pays twice a year, then you will get a check twice a year for $20.00.

And you will get a check for $1000 at maturity.

It really is that simple.

Except that you did not pay $1000 for that bond. You either paid more or less, depending on what the prevailing interest rates were at the time you bought the bond (i.e., what interest rate is available on newly issued bonds with the same amount of time to maturity, from a company with the same credit rating).

Over the life of the bond, the market price will rise and fall. If you bought the bond on Monday for $1063, by Friday that same bond could be trading at $971. Or it could be trading at $1092.

But that does not mean that "the principal declines." The face value of the bond is still $1000, and that is what you will get if you wait until maturity. It is the market price that goes up and down.

The other thing that may be confusing you is the yield.

Your yield is based on certain assumptions, e.g., that you are going to hold the bond until maturity, and that it will not be called early (i.e., paid off early), and that the issuer does not go into bankruptcy.

Your yield is a function of the price you paid for the bond and the interest rate. After you purchase the bond, the price you paid is never going to change, and the interest rate is never going to change. So your yield will not change.

But when you look up the current price of the bond, say, a week after you bought it, or a month after you bought, it will show a different yield because it is calculating the yield based on the current market price.

BMK

So then all else equal, if not planning to hold until maturity (10 yrs is a long time to hold) we just want the price to go up to sell at a profit? (I have no idea how I'd calculate a total return)

 

[Real Money]

I hear commentators get excited when the rate goes up (i.e. "you can get 5% risk free!") If the rate goes up I get more interest (great), but the principal declines. I know I'm missing something..

So what do I want to happen if I buy a bond (and don't hold to maturity)?

Oh, I get it. If you buy something like TLT, you want rates to go down.

The institutions are holding bonds while short rate futures to protect their principle (liquidity position). That or they are long rate options (puts) to protect their capital. If you just own the ETF you have unhedged rate risk that can cause you to be illiquid relative to what you paid prior the purchase of the securities.

Hope that helps.

 

[LaxFan]

Oh, I get it. If you buy something like TLT, you want rates to go down.

The institutions are holding bonds while short rate futures to protect their principle. That or they are long rate options (puts) to protect their capital. If you just own the ETF you have unhedged rate risk that can cause you to be illiquid relative to what you paid prior the purchase of the securities.

Hope that helps.

Actually the second paragraph is more confusing...That's why I stick to the zero-coupon T-bills which I understand or something like AGG for if I want a bond ETF (even though I don't understand how it works it gives the bond exposure).

 

[BMK]

So then all else equal, if not planning to hold until maturity (10 yrs is a long time to hold) we just want the price to go up to sell at a profit? (I have no idea how I'd calculate a total return)

If interest rates go down after you buy the bond, then the market price will go up, and you will be able to sell the bond at profit (capital gain).

The total return should be the gain (or loss) on the sale of the bond (the difference between what you paid for it and what you sold it for) plus or minus any interest that you paid and/or received.

When you buy a bond, you receive a pro-rated amount of interest that is determined by the amount of time that has passed since the last interest payment.

When you sell a bond, you pay a pro-rated amount of interest that is calculated the same way.

The pro-rated interest that you pay or receive is built into the price of the bond. You can see the amount in the quote, or in your trade confirmation. It is usually called accrued interest.

Yes, the calculations are little different for a zero-coupon bond, because a zero-coupon bond has only one interest payment--at maturity. But the basic concept is the same.