Ideally, you want to buy bonds when interest rates are at their peak, or monetary policy is tightest, because bond prices are at their corresponding lows.
Bonds and debentures come in a wide variety of stripes, from straight to zero-coupon to floating rates to convertible, and many more besides.
Regardless of the type of bond or debenture, though, there are five basic rules to which all bond prices must subscribe. Knowing these five pricing properties, and how they interact with each other, will take you a long way to knowing everything you will ever need to know about bonds.
What’s more, all bonds will always follow all five rules, more or less. Or perhaps we should say that no bond will violate those five rules. Some types of bonds will follow the rules more strictly, and some less so, but none will violate the rules outright.
Rule No. 1
The first bond pricing principle is that bond prices and bond yields are inversely related. When a bond’s price rises, its yield falls, and vice versa.
Moreover, since interest rates and yields both represent rates of return on debt or debt securities, and interest rates and yields correlate highly, we can also say that when interest rates rise, bond prices fall, and vice versa.
To understand why interest rates and bond prices are inversely related, we need to recognize that the total return from a bond comes from two sources: the regular interest income it pays, and any capital gain or loss resulting from the difference between the price you buy it at and the price you sell it at. Essentially, if the interest income is not high enough on its own, the price will have to get cheaper so that capital gains make up the difference.
If interest rates are five per cent, for example, and a bond pays four per cent interest, the bond will have to offer one per cent in annual capital gains to compensate. Roughly speaking (leaving out compounding for simplicity), the bond’s price should be discounted by one per cent for each year that remains on its life. A three-year bond, for example, would drop about three per cent in price to make up the difference between the four per cent it pays in interest and the five per cent it’s expected to return.
Ideally, then, you want to buy bonds when interest rates are at their peak, or monetary policy is tightest, because bond prices are at their corresponding lows.
Then, you may want to hold those bonds as interest rates fall, and sell them when interest rates are at their lowest, and monetary policy begins to tighten again.
Some exceptions to the rule
Is the inverse price-yield phenomenon discussed above universal to all bonds? Not exactly, there are some exceptions.
But for the most part it’s true. Short-term bonds, long-term bonds, low-coupon bonds, high coupon bonds—virtually all bonds—rise in price when interest rates fall, and vice versa.
There are isolated cases where an increase in interest rates will not be corresponded with by a drop in a bond’s price. Very, very long-term bonds (maturities more than 50 years) and perpetual bonds may show very little if any drop in price when interest rates rise.
Also, convertible bonds where the underlying common shares are trading well above the conversion price, and the bond is not yet callable, may not react to changes in interest rates, up or down.
This is an edited version of an article that was originally published for subscribers in the December 11, 2020, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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