By Charles Ross, Contributor 
Ross
ONE OF the key features that make global bonds attractive to investors is the ability to sell the bond at any time and avoid having to hold it to maturity. This is possible because of the nature of the bond contracts and the extensive trading system that exists to support the market for bonds. A key function of the market is to set the price at which bonds will trade at specific points in time. This price is, of course, set by willing buyers and sellers exchanging bonds for cash and vice versa. But just what is the process for setting that price?
SETTING THE PRICE
The price of a bond is initially set in relation to a "par" or face value of 100. In other words, the price of the bond is usually quoted as the price per $100.00 of the bond's face value. This means that a person buying a bond at par would pay $100 for each $100.00 of the principal of the bond. The par value of the bond represents its nominal value and is the basis on which interest is paid on the coupon or interest payment dates that are specified when the bond is issued. For example, if an investor owned $100.00 face value of a bond that had a coupon of 10 per cent, paid semi-annually, he or she would receive $5.00 in interest on each coupon date ($100x10%/2).
Now, if the price of that same bond were to rise to $105.00 or fall to $95.00, the investor who owned $100.00 face value of the bond would still get only $5.00 in interest on the coupon dates. However, someone buying that $100.00 face value of bond would have to pay the going price of say $105.00 - that is, the purchaser would pay a premium for the bond and the seller would make a capital gain of $5.00 on his investment. On the other hand, if the price of the bond had fallen to $95.00, the purchaser would pay only $95.00 and the seller would experience a capital loss of $5.00. Note that when a bond is trading at a price which is above par, it is said to be trading at a premium; when it is trading at a price which is below par, it is said to be trading at a discount.
HOW TRADING PRICE AFFECTS YIELD
The price at which an investor buys a bond will have a direct impact on the yield or effective interest rate that he earns on his investment in the bond. This holds true whether a bond is trading at a premium or at a discount. In fact, because the interest that is paid on the bond is fixed, yield tends to move in an inverse relationship to the price. Put another way, the higher the price a new purchaser pays for a bond, the lower will be the yield on that bond and vice versa. For example, if a bond with a 10 per cent coupon is purchased at $10.00 above par, the investor will still earn only the fixed $10.00 of interest per annum, despite the fact that he bought the bond at a premium.
CALCULATING CURRENT YIELD
While the investor is holding that bond, bought at premium, his effective interest rate or current yield would be 9.1 per cent, calculated as follows: Current yield = 9.1 per cent
The investor's yield to maturity - which will be earned if the bond is held until it is redeemed - would be even less since, at maturity, the investor would receive only the par value of the bonds and not the $10.00 above par that was paid. While calculation of the yield to maturity is a little more complicated than the current yield - primarily because it involves discounting the premium that was paid for the bonds over the time remaining to maturity - there are formulae that allow this figure to be calculated very quickly, using a computer or a financial calculator.
Again, it is important to note that, because the coupon on the bond and the maturity date of the bond are usually fixed, when an investor buys a bond, the price that is paid determines both the current yield and the yield to maturity and these do not change as long as the issuer continues to honour the bonds. Whether the price of the bond goes up or down subsequent to the purchase of the bond, the investor's yield to maturity will remain the same as long as he continues to hold the bond. If he decides to sell the bond before maturity, the price at which he sells will determine whether he makes a capital gain or loss or whether he simply earned the current yield while he held the bond. As you can see from the above, bond prices are central to determining the returns on investments in bonds and in a subsequent article, we will look at some of the factors that affect both the market for bonds and their pricing.
Charles Ross is Managing Director of Sterling Asset Management Ltd.
