Last week we discussed basic concepts and terminology regarding bond investments. Recall that bonds represent fractional participation in loans made to corporations, municipalities and even sovereign nations. A bondholder is promised a certain fixed amount upon maturity, and periodic interest payments at intervals along the way. The anticipated or expected rate of return is a function of time to maturity as well as risk of non-payment.

Today we will walk through an example of how bonds are priced in the market. It is this aspect that is perhaps least well understood by investors.

Consider a bond issued yesterday by Johnson and Johnson. It has a 2.5 percent coupon rate, AAA credit rating, and matures in 10 years at a face (par) value of $1,000. At the time of issue, the market interest rate was also 2.5 percent for bonds of this quality.

How much would you invest today to receive $1,000 ten years from now? Presumably less than $1,000, since you must be compensated for inflation and receive some modest reward for your trouble. On average, investors are currently willing to accept 2.5 percent annually for this exchange, so the par value must be reduced or “discounted” such that the final payment results in an annual return of 2.5 percent. A simple computation yields a present value of $780. Investors will pay $780 today to get $1,000 in 10 years as long at interest rates remain at 2.5 percent.

Christopher Hopkins

Photo by Contributed Photo /Times Free Press.

For some bonds, that’s the extent of it. “Zero coupon” bonds make no payments along the way but can be purchased at a deep discount. This is exactly how U.S. Savings Bonds operate, and this type of instrument can be useful in matching long-term liabilities like estimated tuition payments years in the future.

Our example, however, includes coupon interest payments to be received twice per year. Each payment of $12.50 will be received at various times in the future, and so each payment is also worth somewhat less in today’s dollars.

We can also compute the present value of all 20 coupon payments we expect to receive. This total, $220, is then added to the $780 present value of the final repayment (par) to arrive at $1,000. Since the market rate of 2.5 percent equals the stated fixed coupon rate, the price of our bond exactly equals the maturity or par value.

Make sense? The price of a bond is equal to today’s value of all the future cash flows one will receive, adjusted (discounted) at the current market interest rate for bonds of similar quality, maturity and safety. That is, the present value of the par and all of the coupon interest payments.

What if interest rates rise to 3 percent next year? Instinctively, one recognizes that our JNJ bond paying $25 per year ($12.50 every six months) must now be worth less than a newly minted version after rates increased promising $30 per year. In fact, the value of our bond falls to $960, obtained by re-computing the current or present value of all those future payments. Since the price of the bond is less than par, it is referred to as a “discount” bond. You still get your $1,000 in nine years and your $12.50 every six months, but they are worth less to you since the market is now offering 3 percent.

Contrariwise, falling market rates beget “premium bonds” priced higher than the par value. In each case, investors receive $1,000 at maturity but prices adjust to net the market rate of return.

Next week: the role of bonds in a diversified portfolio.

[Source”pcworld”]