Let's Talk About Bonds (Part 2)

Personal Money Planning |

By Gary Silverman, CFP®

Last column we introduced the basics of bonds. We started an example where you purchased a 20-year bond at issuance (in the beginning from the company borrowing the money) for $1000 that pays 5% per year. Before we proceed, let’s look at those two numbers.

The $1000 you paid for your bond was the agreement between you and the company issuing it. In 20 years from issuance the holder of the bond (currently you) will get the $1000 loan money back. In the meantime, each year the bond holder (still you) gets $50 in interest.

But what if five years later you decide that you don’t need the $50 in interest each year? In other words, what if you need the $1000 now? Here’s where it gets interesting. You see, the agreement between the company and you was for a 20-year loan, not a 5-year loan. You can’t make the company take back the bond and give you your $1000. Instead, you’ll have to find someone who will buy your bond from you.

Selling a bond is not at all like selling a stock. There is no continuous market and there are no readily available bid-ask prices. The process for matching a buyer and a seller is not designed for the individual investor. Realize that many bonds don’t trade on a daily basis. Some don’t trade for months. So instead of just clicking a few buttons on your phone to turn the bond into cash, you’ll need the services of the friendly bond desk at your broker.

The folks at that desk will then go out and contact a lot of firms who buy and sell bonds for themselves or their clients and ask them to bid on your bond. In most cases this happens within an hour or so.

Going back to the beginning, the bond you are looking to trade is a 20-year bond paying a 5% rate, which you paid $1000. However, that is not what it is now. Remember we are now five years later, so you actually have a 15-year bond that pays $50 per year. That 5% was based on the price you paid for it-- the percentage no longer matters—and neither does the $1000 you originally paid. And as you may have guessed, just because you paid $1000 for it five years ago doesn’t mean it is worth $1000 now.

This may be good or bad news as several things have changed over those five years.

Typically, the longer-term the bond, the more interest it pays. Your bond is now shorter so that’s a bummer. Also, that trading desk has to make money somewhere in the transaction, as does the one on the buy side—that will put a drag on the price you get. The company may have improved its credit rating which would make your bond more valuable, or it may have had a hard time of it which will depress the price.

Then there are interest rates: Your bond pays $50 per year. If nice, new 15-year bonds pay more now, then your bond is worth less. If the newer bonds pay less, then your bond is worth more.

More on this next time.

Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing.