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Bonds: How bond prices move

Created:
23 May 2008
Written by:
Mark Glowrey

The prices at which individual shares trade vary greatly. Even within the fairly homogenous FTSE100 we find ITV trading at 64p whilst Xstrata trades at over £39 a share at the time of writing. Little can be derived from these absolute price levels and the passage of time may see both these shares trading at completely different levels.

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Not so bonds. A quick glance at a list of Gilts or corporate bonds will show the majority of these instruments trading at prices reasonably close to 100. This figure represents a pricing notation based on "pennies in the pound". Typically a bond will be launched at a price of, or close to "par", or 100p in the pound. As time goes on this price will move up or down according to supply and demand in the market until the bond reaches maturity. At this point in time, the bond will be redeemed at 100p in the pound. Thus an investor buying the bond at par is assured of the return of his capital in the future, whatever the market price fluctuations.

The effect of price on yield

Once a bond is trading in the secondary market, the price is free to rise and fall. Taking the example of the European Investment Bank 4.5% January 2013 bond, this security was issued in January 2003 at a price of 98.52. The bond had ten years to maturity at that time and the yield at issue was 4.785%, this being a function of the coupon and the 1.48% discount to par.

Over time, the bond has traded up and down, primarily influenced by a combination of the prevailing interest rates and investor expectation for future interest rates. A price high was seen in 2002 at 103, whilst the low was reached just above 92 in 2006. This is not an untypical trading range for a high quality bond, although more speculative corporate bonds and undated bonds may see greater deviations from par.

To help us understand these price movements, consider that as interest rates rise, the value of the fixed 4.5 per cent coupon is diminished, and the price of the bond falls. Conversely in an environment of falling rates, investors will rush to lock in a fixed yield, bidding up the price of the bond. This is the key point to remember when dealing bonds; price and yield move inversely.

Buying a bond

Firstly, the investors should become acquainted with the minimum denomination of the instrument. In the case of many Sterling corporate bonds, this is a £1,000 "piece", however in some more recent issues it may be as high as £50,000. More helpfully for the private investor, Gilts have a minimum denomination of just £1.

Next consider the price of the bond. If the instrument is trading at par (100p), the yield will, for all intents and purposes, be the same as the coupon. If the price drops below par, the yield will be increased, both by the capital gain as the bond rolls up to par, and by the gearing effect on the coupon.

This effect gets more noticeable as the bond draws closer to maturity. Consider two bonds, the first with a coupon of 5 per cent and one year to run to maturity; the second with the same coupon but five years left to run. Let us suppose that both bonds are trading at 92p in the pound:

5yr bond trading at 92p. Here the yield will be:

5% coupon paid on nominal value of the bond, thus 100/92 x 5% = 5.4% (the running yield)

Plus, a capital gain of 8 points over five years, or 1.6% per year.

Thus, adding the two together will give us a total yield of 7%.

Consider, however, the one year bond. If this was also trading at 92p, the effect of the 8p discount would be much more dramatic. Although the running yield would be unchanged at 5.4% thanks to the gearing effect of the below-par price, the capital gain of 8 points will be achieved over just one year, effectively an 8% pick up in yield. Thus the total yield will be in excess of 13%.

Investors should bear this in mind. The shorter the bond, the greater the sensitivity of the yield to even small shifts in price.

Note; More sophisticated yield calculations can be performed using established market conventions such as the yield to maturity formula. You can read more about this on the www.fixedincominvestor.co.uk website by clicking HERE.

MORE ON INVESTING IN BONDS AND GILTS:

What are gilts?

Investing in gilt funds

What are corporate bonds?

Corporate bond funds

Direct investment in corporate bonds

Bond of the week

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