Bonds are sold in primary and secondary bond markets.
The primary market is small and is for newly issued bonds.
The secondary market is where investors can buy and sell bonds that have already been
issued.
The majority of bonds are bought and sold here.
In this video, we'll examine how bonds are issued, how they enter the primary market,
and how they can end up in the secondary market.
You'll also learn how you can compare bonds before purchasing them.
Let's start by defining a bond.
A bond is issued by an entity, like a corporation, government, or municipality, to raise money.
Issuing a bond is a lot of work, so the issuing entity will hire an underwriting company to
help.
Together, the underwriting company and the entity will determine the bond's details,
including its length to maturity and coupon rate.
A bond's maturity is the time period it will pay interest.
This may be anywhere from one to 30 years.
The face value, or par value, is the bond's value when it's first issued.
A bond's face value is commonly $1,000.
The coupon rate is the percentage of interest the bond issuer pays the bondholder, usually
in semi-annual installments.
The rate is fixed over the life of the bond.
For example, a bond may have a face value of $1,000 and a coupon rate of 5%.
With this rate, the bond would pay a coupon payment of $25 two times each year.
The coupon rate is determined by a number of factors, such as competing bond coupon
rates and the issuing entity's credit rating.
After determining the bond's details, the underwriting company will form a syndicate
of bond sellers, who will pay the issuing entity for the bonds and sell the bonds to
their customers.
If you purchased a newly issued bond, you might be able to do so at face value.
However, if the bond was in the secondary market, you'd probably pay a different price.
Bond prices fluctuate for a number of reasons but one of the most common is changes in interest
rates.
If interest rates rise, bond prices fall.
If interest rates fall, bond prices rise.
The potential for bond prices to rise or fall due to changing interest rates is known as
interest-rate risk.
For example, let's say a new bond was issued for $1,000 with a coupon rate of 5%.
However, over a few months, interest rates edged up and the bond is currently priced
at $998.
This means the bond is trading at a discount.
Now, let's see what would happen if the opposite occurred.
If interest rates fell, the bond would be trading above $1,000.
In this case, the bond is trading at a premium.
If you purchase a bond at a price different than its face value, you receive a different
rate of return than its coupon rate.
This is because a bond's coupon payment is fixed.
While a bond's price may fluctuate, its payments remain the same.
For example, suppose you purchased that same $1,000 bond for less than face value.
Because you paid less than face value, the bond's 5% coupon rate would offer a real
rate of return of 5.03%.
This adjusted rate of return is known as the yield to maturity.
The yield to maturity accounts for a bond's current price, coupon rate, and time left
until maturity.
The yield to maturity allows you to compare new bonds to older bonds, which is important
when buying or selling bonds in the secondary market.
The secondary market is simply where current bondholders sell bonds to investors.
When purchasing a bond in the secondary market, it's important to consider the bond details,
including its price, yield to maturity, and rating.
Bond ratings come from independent companies and are used to rate the creditworthiness
of bond issuers.
When comparing bonds of a similar yield to maturity, look for ones with the highest rating.
After finding a bond that has a yield to maturity and rating that you're comfortable with,
you may move forward and purchase it.
Knowing how bonds are bought and sold, and how to compare them using ratings and yield
to maturity, will help you better understand how the bond market works.
Understanding these details can help you make better decisions when adding bonds to your
portfolio.