On the “golden rule” in bond trading: What is a bond, and how does it change in price
In this piece a definition of a bond is given, before discussing the idea of discounting. Given the explanation of discounting, an application of this idea is made to the cash flows in a typical “bullet” bond is provided, before an example of what a change in the traded yield means is provided, before defining the “golden rule” for bond trading. One of the reasons for indicating all this is that the bond market is much larger in size than the share, or equity, market. In other words, by coming to grips with the following ideas, one can much better understand the largest financial market in the world. The importance of bonds to NSL is evident in the large allocation that NSL has made to bonds in the investment portfolio that it maintains.
Generally, a bond is a debt obligation of an issuer to a bond holder, which typically has the
- face value: this is the end payment, for bullet bonds, say it is PGK 100 m,
- coupon: the income received on the bond, which is usually paid semi-annually. Coupons can
be fixed rate, can be floating rate, or can be linked to some published index, like the Australian
CPI. In this case make the coupon 10%, and
- maturity: this is when the bond is repaid. In this case the maturity is 5 years, meaning 10
coupon payments, and
- format, annuity, bullet, or capital indexed: this is whether, or not principal is repaid
gradually through the life of bond, in the case of an annuity, or what is known as a “bullet”, where the face value is all paid back at once, or capital indexed, where the capital value of the bond rises or falls with an index. Most bonds are “bullets”, and in this case it will be assumed to be a bullet.
All the payments of a bond are discounted, where discounting indicates the maturity payment
amount for a future payment, plus an interest amount. So, if one wants to purchase a discounted security, for PGK 99m, which matures in one year, at a discount rate of 10%, then one would not pay PGK 99m for that security, because the interest on the principal will be paid at the maturity.
Although a discounting formula needs to be used to determine the exact price, roughly one pays roughly PGK 90m, with roughly PGK 9m that accrues for interest, where the final payment is PGK 99m. Hence, the payment made by the purchaser is only PGK 90m, for a final payment to the purchaser, from the issuer, of PGK 99m.
This idea of discounting is really important, as it is used all through the pricing of bonds.
Bond cash flows at “par”, at “primary” issuance
A bond is simply a combination of the following discounted amounts:
- the coupons, which typically are paid twice a year, in this case each half yearly payment is 5%, or the 10% coupon, as specified above, divided by two, and
- the face value, which is in this case is a PGK 100m amount made in five years, at a discount rate of 10%.
“Primary” issuance, is when the bond is issued, by the bond issuer, to a bond holder. When a bond is issued in the “primary” market, it is usually issued at what is known at “par”, or when the traded yield that equals the coupon. When the traded yield of a bond equals the coupon, which is known as the ‘par’ yield, the settlement price of the bond is typically very close to 100, ignoring accrued interest on the bond.
Now, comes the interesting part, as a bond is usually not traded at “par”, when the bond trades in the “secondary” market, which occurs after “primary” issuance has occurred. Typically, market participants don’t agree with the pricing of the bond, right from the point of primary issuance, so they typically either trade the bond at a higher, or lower, yield than the ‘par’ yield. Importantly, if the participants think the yield at primary issuance, or the “par” yield, is too high, then they will purchase it at a lower yield.
Reasons for this fall might be, among others, as follows:
- the market is expecting the BPNG to loosen monetary policy, or
- that the credit worthiness of the company has improved, or
- that other equivalent issuers, at equivalent maturities and structures, have fallen in yield.
There are many reasons that can cause this change, and if one assumes that the market now prices the traded yield of this bond at 9%, not 10%; or not the ‘par’ yield, then the discounted values of all the coupons, and the discounted value of the face value of the bond will all increase.
Pricing and trading bonds involves a transaction volume, excluding derivatives on fixed income, many times larger than equity market transactions. Hence, it is quite an important thing for someone to come to grips with the above ideas, given the enormous traded volume of bonds in global financial markets.
The traded yield is crucial, as it can significantly change the bond settlement value by a large amount. Usually, bond traders talk about a ‘par’ price for a bond as being 100. All this means is that the price is 100% of whatever the face value might be, so that one multiplies the face value by 1.00. Accordingly, a PGK 100m bond at a price of 100, is PGK 100m multiplied by 1.00; PGK 100m.
Now in the case just referred to, when the traded yield falls to 9%, from the ‘par’ yield, of 10%,, then the bond settlement value rises from 100 to 103.90. This means that the PGK 100m bond, as issued at par, or a settlement price of 100, is now worth PGK 100m multiplied by the new settlement price of 1.039, or approximately PGK 103.9 m. In other words, a decline in traded yields has just forced up the price by PGK 3.9m.
Alternatively, if the traded yield was higher than the ‘par’ yield, then the opposite will occur, and all the discounted values of the bond will fall; all the coupons as well as the face value.
This leads to the golden rule in bond pricing; when yields rise, bond prices fall, and when yields fall, bond prices rise.
If one can appreciate this golden rule, then one can have some small insight into the largest financial market in the world; the bond market.