When purchasing bonds, it is essential that as an investor you understand bond prices. And while the concept is not very simple to wrap your mind around, it cab be learned. So let’s explore what bond prices are and most importantly, what they mean to you as an investor.
Understanding Bond Prices
The first thing you should know about bond prices is that they mean much more than simply listing a rate related to your bonds. They actually go as far as to forecast future economic activity, as well as future interest rates. In other words, they’re pretty important. So how are bond prices determined? They represent a percentage of the bond’s principal balance (also known as par value or loan amount). So for instance, if you see a bond quoted at 99-29 ¾ for a two-year bond, and you were to buy a two-year $10,000 bond, you would pay a starting price of $9,992.97 to receive your full payout at the end of two years. The 99 in the number is called the “handle,” and the 29 ¾ is called the “32nds.” To figure how those numbers calculated your price, they must be converted into percentages. To do this, you would first divide the “32nd” value by 32 (29.75 / 32 = .9296875) then add the “handle” to this value. This equals 92.9296875%, which would then be multiplied by $10,000 to make $9,992.96875, or $9,992.97.
Bond Prices and Yields
In the investment world, bond prices and yields are like two peas in a pod. So you’re probably wondering, just what is a yield? The yield is the discount rate that relates a bond’s dollar price to its cash flows (which consist of both coupon (interest) payments and the return of your principal amount). It makes the present value of the bond’s cash flow equal to its price. Whichever direction the price is moving, the yield is moving in the opposite direction. So for instance, if a 2-year bond has a price of 99-29 ¾ and the 3-year bond has a price of 98-28 ¼ then the corresponding yields might stand at 4.91 and 4.93, respectively. See how the prices moved down and the yields moved up? This is an occurrence that you should expect when looking at bonds. There is more to learn if you want a deeper understanding of bond prices, but this should get you started. So keep researching your heart out to learn everything you need to know before purchasing some bonds.