Tuesday, March 5, 2013

Investment Part 2: Bond Pricing

Last week's post dealt with outlining the basic concept of investment and covering a few examples. If you haven't read that yet you can find it here. As a brief overview, investment primarily deals with using excess resources now to secure more resources in the future. Generally this amounts to expending money in order to obtain a revenue stream or payment in the future.

This posting and the next will deal primarily with how the two most infamous investment types, stocks and bonds, are priced.  Many of these principles can be applied to the other market investments (currencies, real estate and commodities) discussed in the previous posting, though often to a lesser extent.

Recall from the previous posting that annuities are payments over a future period in exchange for a payment now. A bond is a debt instrument, meaning you are lending your funds to another legal entity, which rewards the lender with an annuity plus the original payment back after a fixed period of time. For example, you might lend General Electric $1000 for ten years. In exchange they would return to you $20 annually plus $1000 at the end of the ten year period. This would award you $1200 overall or $200 more than your original investment.

There are two major factors that effect bond prices, risk and interest rates. Risk is generally expressed by bond ratings ranging from AAA (least risky) to D (most risky). Within a given credit rating there is an interest rate sufficient to incentive investors enough to lend their money to the firm.  As risk increases the interest rate required rises and thus return increases.  Correspondingly the risk of receiving no return (due to default) increases as well.

It's important to understand that the most important factor in terms of bond price changes is not the bonds rating at time of issue.  $1000 B rated bonds are issued at a cost of $1000 as are bonds of any other rating. The difference at the time of issue is the interest rate the bonds repay. So a B rated bond will pay a lesser interest rate due to being less risky than a C rated bond but both will cost $1000 dollars (or any other arbitrary amount) when issued. However, suppose Conglomerated Widgets was downgraded from B+ to B rating.  The interest rate of the bond can not change. Therefore it is still paying an interest rate appropriate for a B+ bond but merits the interest rate of a B bond.  Why would anyone accept a lesser interest rate for increased risk? In order to incentivize investors the bond must now be sold for less than other similar bonds. The interest (coupon) payments are the same, the bond will still return the $1000 dollars at maturity but because it has been deemed more risky than expected it is worth less.

Imagine someone asked you to buy our Conglomerated Widgets bond the day before maturity. Assuming the person was relatively trustworthy how much would you pay? It's very unlikely that the firm is going to default on it's debt before tomorrow so you'd probably pay slightly less than $1000. Suppose you were asked to make the purchase five years before maturity. Now the increased risk probably has a much larger impact on your decision and thus you're unwilling to pay as much. This is a fundamental principle of bonds. As bonds approach maturity their price also approaches their "par value" or the amount they will return to the investor upon maturity.  This is another example of how risk effects bond prices.  As maturity approaches there is less time for anything to go wrong (usually meaning default) with the bond. Thus as the risk abates the bond price tends towards it's par value.  Similarly if the firm's rating that issued the bond had been upgraded the upgrade would become less meaningful as maturity approached and the bond would decrease to par value.

Interest rates also have a profound effect on bond prices.  Understanding how interest rates are set is unimportant to understanding bond prices so for simplicity's sake imagine every year on January 1st the United States says they will use the final digit of the year (so 3% in 2013) to determine what interest rate they will repay ten year bonds at for that year. Further, suppose the United States is considered the absolute safest possible investment. If you were Conglomerated Widgets (CW) would you be able to get much funding if you issued bonds at the same interest rate as the United States? Probably not. You're going to have to provide an interest rate higher than the government in order to attract investors to your riskier debt. Let's imagine that CW has to have a coupon rate of 3% higher than the USA each year. Therefore in 2000 they issued ten year bonds at 3%, 4% in 2001, 5% in 2002 and so on and so on. Now it's 2013 and you have a number of options.

You can buy into the new bond issuance that will reward you $60 a year and $1000 in ten years.
You can buy last years bonds that reward you $50 a year and $1000 in nine years.
You can buy 2011's bonds that reward you $40 a year and $1000 in eight years.
You can buy 2010's bonds that reward you $30 a year and $1000 in seven years.
You can buy 2009's bonds that reward you $120 a year and $1000 in six years.
You can buy 2008's bonds that reward you $110 a year and $1000 in five years.
You can buy 2007's bonds that reward you $100 a year and $1000 in four years.
You can buy 2006's bonds that reward you $90 a year and $1000 in three years.
You can buy 2005's bonds that reward you $80 a year and $1000 in two years.
You can buy 2004's bonds that reward you $70 a year and $1000 in one year.
You can buy 2003's bonds that reward you $1000 now.

We already established that a bond close to maturity will cost approximately the par value so buying 2003's bond for $1000 in order to get $1000 is probably not the best plan. You'd make some money nearly guaranteed, but not very much.  How would you compare the debt between 2009 and 2010? Clearly the bonds issued in 2009 are a much better deal. You have to wait an additional year to collect your $1000 but you gain over $500 more while you wait for maturity. Thus 2009's bonds would sell at a premium because they're more desirable due to their higher than average yearly return.  2010's bonds however would sell at a discount because it's interest rate is lower than the current rate necessary for CW's investment class to attract funds. The key lesson behind the bond/interest rate relationship is that if the bond's interest rate is lower than the current prevailing interest rate for that class of investments the bond will sell for below par value. Conversely if the bonds rate is higher than the prevailing rate it will sell at a premium. Regardless of premium or discount as the bond approaches maturity it will trend towards it's par value.

All of the above examples are an effort in understanding the factors that cause changes in bond prices. If you were hoping for explanations regarding how to exactly price specific bonds you can find more information on that topic here.

So to summarize, how can you make money with bonds? Well, just holding a bond will generally pay money due to coupon payments and the par value.  However, if you believe interest rates will fall (thus making your existing bonds more attractive and valuable) bonds are a sound investment.  If you believe a certain company will receive a credit rating upgrade, their bonds would also be a wise purchase.  However, in general bonds are considered a relatively low risk, low reward investment. It's unlikely you'll make a fortune in the bond markets but it may be a reasonable way to preserve and slowly grow your wealth.

Next week I'll tackle stocks and how they're priced. Afterwards Bounded Rationality will return to it's usual impractical academic musings.

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