Investing Strategies - Part VIII

Bond Pricing

In my last post, I made mention of the fact that many bond investors are not aware of how the bond market prices securities. I also noted that in my original post on the bare basics of bond investing, I did not touch on it either. But since it is important to the full understanding of the article linked in the last post, let's have a go at it.

Bond prices are essentially composed of a few different components. The first is the risk free rate of return. There is also a component of interest rate risk and a component for company specific risk. In addition there may also be components of currency risk, political risk, or key persons risk. But that's not all.

There is also a question of how do you actually price a bond? To a point, it depends on what your goal in investing in that bond is. In other words, are you investing for the long term or are you simply speculating?

All these factors together make understand bond pricing and price dynamics one of the most complex areas in the market. So let's break them down one by one and see if we can't get a better understanding of how they all work and interrelate.

As I said, the first - and most important - component of bond pricing is the risk free rate of return. This number is essentially the fed funds rate, that magical number set by Greenspan and Federal Reserve. Often times, you'll hear the risk free rate described as being the return on Treasuries. Treasuries are often used as a rule of thumb proxy for comparison purposes (mainly because they are government backed), but they are not completely accurate because of interest rate risk, our second component.

Interest rate risk is how the bond market takes into account future expectations of either a rate cut or increase. It is often said in the industry that the bond market leads Greenspan, not the other way around. Treasuries are susceptible to interest rate risk just like every other bond, which is why they are not truly a risk free rate of return. Treasury risk ends (theoretically) at interest rate risk. Most bonds, including munis include a component of company risk.

Company risk is how the market accounts for risks unique to the issuer. In a way, this is a bit of a misnomer as issuers of muni bonds also have differing degrees of risk. For instance, right now it would be a greater risk to invest in a State of California muni than it would to buy one issued by, say, the State of Virginia. This is partially offset by the fact that virtually every muni is insured, but then the financial strength of the insurer comes into play in determining the company risk component. The degree of company risk will almost always be reported by either Moody's or S & P, using a variation of the AAA (or 3a), AA (or 2a) through D (which stands for in Default). AAA bonds will be priced very close to, and sometimes even at, the yield of a similar Treasury. CCC bonds will be priced to have a much higher yield, reflecting their higher company risk component.

Those are the three most common components used in determining bond prices. However, when you have a bond payable in a foreign currency (Euro denominated bonds are becoming more prevalent), you introduce the currency exchange rate risk. If a issuer is a foreign company, or the bond is secured by overseas assets, you now introduce the political risk, which is mainly concerned with nationalization or currency export restrictions. And with some, usually smaller, companies if one person is perceived as being key to the viability of the company, there may be a key person risk factor that comes into play.

So once you've determined all the various risks, do you have a useful price? Probably. The tricky part is in identifying it.

Most bonds are quoted two ways: by yield to maturity (YTM) and by the actual trading price. The YTM will be a percentage, such as 5 3/4%. The actual trading price will be quoted as say 90 3/4 (which should be read as $907.50 per $1000 par value - multiply by 100 to get the actual price). Treasuries are an exception, they're priced in 32nds, i.e. 98:15 or 98 and 15/32.

So which is the right number for you? Depends on what you're looking to achieve. If you're investing for the long term, the YTM will be the more important number for you. YTMs are relatively low right now because of the low Fed funds rate. So, as a result, people are taking more risk (investing in lower grade bonds, generally) in order to get a YTM that is acceptable. If you're looking for a short term trade, you'll be more concerned with the actual trading price of the bond as your goal will to make money on the capital gain rather than through the accumulation of interest.

So how do bond pricing and YTM work in relation to interest rates?

Let's assume that interest rates are going up. The YTM will also go up, as the risk free rate base will be rising. But since the coupon rate will not change, the only way to push up the YTM is for the price to go down.

On the other hand, if interest rates are going down, YTM will follow suit and the price will rise, as again, the coupon rate is fixed by the bond covenant.

This is where the real risk in investing in bonds right now comes in. Interest rates are virtually at zero as it is. There is really no place for them to go but up, which in turn will push down bond prices. Speculating in bonds right now may be profitable, but if you're buying for the long term you had best be planning to hold to maturity and had better be happy with the YTM as it is unlikely that you'll be selling a bond at a capital gain in the intermediate term.

But all is not lost in the bond market, if you're willing to be patient and intelligent in your investing.

If you need to put money into bonds for allocation reasons, or because you feel it is more safe than putting money in the stock market, investigate your choices. This is probably a very good time to be looking at short term bond mutual funds. Why?

As bonds get closer to maturity the risk components move towards zero and the prices become less volatile. Returns will be small, whether they be positive or negative. In a market where prices are likely to be falling, capital preservation becomes the name of the game (unless you're trying to short the market, but that's a whole 'nother story).

How can you compare different mutual funds to see which may be more appropriate for you? Look for the statistic labeled "duration." It is a measure of the average time to maturity for the fund's bond investments. The smaller the number, the closer to maturity the average bond is, the less volatile the fund will be, and the lower the potential return will be.

As always, talk things over with your broker before making any investment decisions. Everything here is for educational purposes only and is not intended to be, nor should it be construed as, a specific recommendation. All investments carry a degree of risk.