Are you confused about how bonds are priced? You’re not alone. Here’s how it works

In my last article, I talked about the basic types and terminologies of bonds.  We learned about terms like coupon rates, par values, and maturities.  The thing that used to confuse me most about bonds is their pricing.  I would hear on the news that interest rates were up, and bond prices were falling.  That didn’t really make sense to me.  Wouldn’t higher interest rates make bonds more attractive?  Actually, it’s the opposite.  Today, I’ll explain how it all works. 

The two types of bond markets

The key to understanding bond valuation is to remember that there are two bond markets—a primary market and a secondary market.  The primary market is where investors buy new bonds, which are being issued all the time.  The secondary market is where existing bonds are subsequently bought and sold.  A bond may be traded in the secondary market until its maturity date (when it expires and the par value, or principal, gets paid out to its owner.)  Ownership of that bond may trade hands many, many times before then.  When you hear about bond pricing on the news, it is generally talking about what is happening in the secondary market. 

How do Fed decisions affect bond prices?

Let’s dive a little bit deeper. Remember, part of the attractiveness of buying bonds as an investor is that they pay out interest.  Bond interest rates are indirectly controlled by the Federal Reserve Bank.  When you hear that the Fed just raised interest rates, this means that they raised something called the federal funds rate. This is merely the short-term interest rates that banks can charge to lend each other a portion of their government-mandated reserve, if they have extra.  That’s it.  But all the other interest rates are secondarily tied to this rate.  If banks have to pay more to other banks to borrow money, they raise the interest rates on the loans that they create for customers, and it all flows into the economy from there.

The federal funds rate also impacts bonds.  Remember, bondholders are like little banks.  They are lending money and expecting interest in return.  If the fed rate is higher and banks are charging their customers more for loans, bondholders can also expect to earn higher interest on the loans they are giving in the form of bonds. 

The bond investor’s two options

This is where it is important to understand the difference between the primary and the secondary markets.  The terms of the bonds that are being sold on the secondary market have already been set. Remember, a bond is a contract. It was created when the bond was sold the first time (on the primary market).  The terms of the contract don’t change.  There is a defined interest rate (coupon rate), par value (principal) and maturity date. 

But economic conditions are always changing and the terms of the new bonds being sold on the primary market reflect that. The going interest rate (the market rate) adjusts based on the Fed action and other economic indicators that might affect the default risk of that bond.  So, when the fed increases interest rates, for example, the coupon rates on new bonds (also known as the nominal yield) are higher. 

Now, think about that from the perspective of a bond investor.  You really have two options.  You can go buy a new bond on the primary market, or you can buy an old bond on the secondary market.  If you could get a new bond from the same issuer at the same term for a higher interest payout rate, why would you buy an older bond that was created when the interest rates were lower?  You wouldn’t.  The new bond will pay you more. 

The secondary market adjusts prices

As an investor, your goal is to maximize the amount of money in your pocket from each investment.  With bonds, you get money in your pocket in two different ways.  One is from the interest that it is paying you, also known as the yield.  The second is when the principal is given back to you when the bond matures. 

Most new bonds cost $1000. We already established that you would never pay the same for an old bond with a lower yield if you could get a new bond with a higher yield, because that is like taking potential money out of your pocket.  But what if you didn’t have to pay full price for the old bond? Instead of paying $1000 for it, they would sell it to you for $950.  At the end of the term, you still get the par value of $1000 because that is written in the contract.  You make $50 on the principal, and you still get the interest payments along the way.  Then you would have to think about it, right? You’d have to do some math.

That is how it works in the secondary market.  The bond prices adjust up or down according to what is available on the primary market.  They are trying to make the old bonds as attractive as new bonds.  If they lower the price to entice the investor, it is called a discount bond.  It can work the other way as well.  If the market rate drops, then older bonds with higher rates become more attractive to investors, and bondholders can charge more for them in the secondary market.  These are called premium bonds.

This graph shows the relationship:

How does that affect your portfolio bond funds?

Most of us don’t buy bonds directly on the primary or secondary markets.  That’s too much work and in the case of corporate bonds, you may not even have access to do it.  Instead, most investors purchase shares in a mutual fund or index fund that is doing all the work of individual bond buying and selling.

These funds may own hundreds or thousands of individual bonds (just like stock funds own shares in many different companies), and then the fund managers trade those bonds on the secondary market. The value or price of each bond is going to fluctuate according to market interest rates, as well as political or economic conditions which might change the default risk of the bond.  If the default risk goes up, the bond price goes down. The aggregate value of the bond fund reflects the ups and downs of the bond market.

The last several years have taught us about the impact of inflation and interest rates on the value of bond funds.  For a long time, we enjoyed low inflation in our economy. The fed sets interest rates according to inflation and unemployment numbers. When inflation goes up, the Fed combats it by raising interest rates. They were able to keep the rates low for decades and bond prices remained quite steady as a result.

But several years ago, in the aftermath of the Covid pandemic and Russia’s war on Ukraine, inflation rose dramatically. In response, the Fed raised rates. And when interest rates rise, bond prices on the secondary market fall (look again at the graph above).  As bond prices go down, the value of your bond fund also goes down.  That is why bond funds have been pummeled over the last few years.

That’s not the entire story

There is a lot more to determining bond pricing than what I have talked about so far, including figuring out things like current yield, yield to maturity (YTM), yield to call (YTC) and yield to worse (YTW). But I don’t think these are necessarily important for you to know if you are not actively purchasing individual bonds yourself.  Hopefully your bond fund manager understands it all.   

The bottom line

Bond prices fall as interest rates rise and vice versa, and that affects the value of the bond funds in your portfolio.  Your bond funds can earn or lose money for you, just like your stock funds.  It is just typically to a lesser degree, meaning that the ups and downs are less extreme, which decreases your overall short-term risk.

Lower volatility is only one of the reasons to consider bonds in your portfolio. The other is for the income—the interest payout.  Regardless of the current value of the bond on the secondary market, bonds still pay out at the rate that was established when the bond was created.  The amount of income that you can expect depends on the mix of bonds in your portfolio and what the bond fund managers do with them on the secondary market.  

What is the “right” percentage of bonds that you should have in your portfolio?  That all depends on things like your risk tolerance (how the ups and downs affect you emotionally), your risk capacity (how much time you have before you need the money), and your current income needs.  These are individual decisions and should be considered in the context of a comprehensive financial plan.  A good fiduciary financial advisor can help you figure it all out. 

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Disclaimer: the material in this blog post is intended for general educational purposes only and should not be considered specific financial advice. You should always consult with your personal financial advisor to see how it might fit within your personalized financial plan.