How to Determine the Selling Price of Bonds
Bonds are essentially IOUs. Corporations and governments issue bonds to borrow money, and the bond owner receives interest. When the bond matures, the money is repaid. However, bonds are traded on markets much like stocks, and their prices vary. This can be confusing at first, since the actual price and the amount the bond is issued for are rarely the same. It’s not difficult to determine the selling price of bonds, but you also need to understand why and how the price varies in order to invest in bonds wisely.
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Instructions
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Understand how bonds work. When a bond is issued it has a face value—usually $1,000 for corporation-issued bonds. The face value of government bonds varies, with municipal bonds sometimes as small as $100 and U.S. Treasury bonds typically having values of $10,000 or even more. The face value is the amount the issuer must pay the bondholder when the bond matures. In the case of a short-term bond, this can be a year or less. Medium and long-term bonds have maturities up to 30 years. The amount of interest a bond pays is called the coupon rate. In the United States, interest is usually paid semi-annually, and the amount—the coupon rate—stays the same for the life of the bond. Thus, a $1,000 (face value) bond with a coupon rate of 10% will pay $100 each year.
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Learn to distinguish between face value and the price of a bond. You buy and sell bonds like you do stocks, by placing an order with a broker. To determine the selling price of bonds, look up a particular bond’s daily price quote in a newspaper or online bond price listing. You will see a figure something like “85.50.” This means the bond is trading at 85.5% of its face value. You have to know the face value of the bond, but you can assume it’s $1,000 for corporate bonds. The selling price of the bond is thus $855.
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Know how interests rates help determine the selling price of bonds. Changes in average interest rates occur for many reasons, but whatever their cause are the most important influence on bond prices. The key to understanding this is that the coupon rate—the dollar amount a bond pays in interest—is fixed. If the coupon rate is higher than the prevailing interest rate, the bond is a better investment. When this happens, the price of the bond will rise above its face value, and we say the bond is selling at a premium. If the reverse happens and the interest rate rises above the coupon rate, the bond is not as attractive to investors, and the price will drop below the face value—the bond is selling at a discount.
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Learn how to estimate the risk of a bond and how this affects its price. Interest isn’t the only thing you need to consider to determine the selling price of bonds. Some bonds are riskier investments than others. If a bond is very low risk, investors will pay more for it (and vice versa). Risk is estimated based on a company’s past record and current situation. Investors rely on rating services like Moody’s to assess bond risk (you can use the link to their site at the end of this article). One more factor to take into account is the time until the bond matures. Long-term bonds carry higher risk because there is more uncertainty about what will happen in 10 to 30 years than in just a year or two.
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Use a yield calculator to find the actual interest rate of a bond. Since the selling price of bonds isn’t the same as the face value, the rate of interest changes as the price changes. Calculating the actual rate of interest can get complicated, so the best way to find the actual yield of a bond at a given price is to use a yield calculator software package. There are free ones available for use on the Internet. A link to the Morningstar yield calculator is at the end of this article.
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