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Bond Pricing:
Educated Investor Center – BondsOnline
All bonds have some common characteristics, but they do not always have
the same contractual features. Differences in contractual provisions, and in
the underlying strength of the companies backing the bonds, lead to major
differences in bonds risks, prices, and expected returns. It is important to
understand how bond markets actually function and what the appropriate
terminology is.
Visit BondsOnline (http://www.bondsonline.com/) to complete this
cyberproblem. You will be using BondsOnline’s Educated Investor Center
(link found on the left) to answer the following questions. Select the tutorial
entitled “Buying Selling and Trading”
a.
What are some of the factors you should consider when buying a
bond?
One of the factors to be considered is maturity. If you hold the
bond until maturity, you get back what you paid for it (unless
the issuer defaults). You should try to match the length of your
investment with your need for funds. If money is required in a
couple years for a big investment, choose a shorter term bond.
If you have a longer investment horizon, choose a longer term
bond, and, generally speaking, longer term bonds usually offer
higher yields.
Investors also must consider call provisions. The ability to call
a bond early allows issuers to take advantage of low interest
rate conditions if they develop.
Another important factor is credit quality. If the issuer is at
risk of default, the bond will be given a low credit rating. Low
credit ratings are consistent with high yields and low prices.
b.
How are Treasury bonds bought?
You can purchase U.S. Treasury bonds on the secondary market
or directly from the Federal Reserve. When you purchase
bonds directly from the Federal Reserve, you must buy new
issues, but there are no broker commissions. The Treasury
holds regularly scheduled government auctions four times a
year: the first weeks of February, May, August, and November.
You can enter competitive bids for Treasury securities.
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c.
What determines the price you will actually pay for a bond and what
intermediaries are involved?
When bonds are first issued, their prices, or face values, are
fixed. After issuance, prices fluctuate in the secondary market
due to changing interest rates. When bonds are first issued,
bond dealers assist the issuer (a company or governmental
body) in selling the bonds to the public, and for this they are
paid a commission from the proceeds of the sale.
Older bonds are sold through brokers in the secondary market,
which consists of the over-the-counter (OTC) market, including
the NASDAQ, and stock exchanges such as the New York Stock
Exchange (NYSE). Most bonds are sold over the counter. The
OTC market consists of hundreds of banks and brokerages that
buy and sell over the phone or via computer networks.
Brokerage firms that deal in bonds have latitude to set prices
for bonds they sell. However, all prices are negotiable. Bonds
sold on the OTC market are usually sold in amounts greater
than $5,000 at a time.
d.
What factors determine a bond’s market price?
The main factors determining a bond’s value are its par value,
its coupon rate, and its yield to maturity.
e.
What role do transaction costs play in bond transactions?
The actual transaction costs you will have to pay depend upon
the market in which you are buying the bonds. The difference
between the price a broker-dealer pays for a bond and the
price at which it is sold to you is known as the bond's markup.
For new issues, the markup is included in the par value, and if
you are interested in a new issue, you can get an offering
statement describing the bond's features and risks.
When you buy or sell bonds through a broker-dealer on the
secondary market, the bonds will have price markups. Instead
of charging you a commission to perform the transaction for
you, the broker-dealer marks up the price of the bond to above
its face value between 1% and 5%. Bond dealers generally
charge higher markups on smaller bond sales than larger ones.
If you are buying a Treasury bond over the counter, you may
have to pay a small, additional flat fee.
Bonds bought on the exchanges generally have much higher
markups than bonds bought over the counter. It is difficult to
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know how much of a markup you are paying, because the
markup is built into the price of the bond.
f.
What is meant by buying bonds indirectly?
There are alternatives to direct bond investing such as unit
investment trusts and bond mutual funds. A UIT gives you the
opportunity to buy a wide variety of bonds in a portfolio that
never changes. The benefit of a UIT is that you know exactly
how much you will earn from the trust when the bonds mature.
You earn interest during the life of the trust on the amount you
initially invest as well as on the trust's income. The bonds in
the trust remain fixed until your initial investment is
completely returned to you when the bonds mature. A trustee
supervises the bonds in the trust, but the trustee cannot sell or
add new bonds.
A bond mutual fund is a portfolio of bonds managed by an
investment professional. The big advantage to a bond fund is
that your investment buys shares of a diversified, managed
portfolio of bonds, which lowers your overall risks. Interest
payments and capital gains from a bond fund can be paid to
you or reinvested into the fund.
f.
Refer back to the Educated Investor Center and take the Daily Quiz.
What is your bond IQ?
The Daily Quiz focuses on a different topic each day, so
questions and answers will vary.
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