Bond prices change even though their payouts remain fixed, and this directly impacts your actual returns. This guide explains how bond pricing works, why prices move, and what it means for you as an investor.
As Mr. Financewala explores bonds on Jiraaf, he starts comparing a few options more closely. He starts noticing that the same bond, with the same issuer and coupon, is available at different prices in the secondary market.
When he got to know about different bond types in the last chapter, he thought he had the bonds figured out, but this detail stops him. He tracks the bond over the next couple of days and notices that its price keeps changing in the secondary market, while the coupon payout remains the same.
Puzzled, Mr. Financewala wonders, “If a bond pays a fixed return, why does its price keep moving? And what does that mean for the return an investor actually earns?”
In chapter 3 of this series, we break down how bond pricing works, so you can understand what works in the background to drive your returns.
How are Bonds Issued in the Market?
As a beginner, the most important thing to understand about bond pricing is that every bond is issued at a face value (Par), their price in the secondary market can be categorized in 3 ways:
- Par
When a bond is trading at its face value. For example, a ₹1,000 bond priced at ₹1,000
- Discount
When a bond is trading at a price lower than its face value. For example, a ₹1,000 bond priced at ₹950
- Premium
When a bond is trading at a price higher than its face value. For example, a ₹1,000 bond priced at ₹1,050
These terms describe how a bond is priced relative to its original value. at the time it is issued. But why would the same bond trade at different price levels?
It usually comes down to a combination of factors:
- Prevailing interest rates
If market interest rates rise above the bond’s coupon rate, the bond price will drop to a discount. If they fall below the coupon rate, it will trade at a premium.
- Demand from investors
Strong demand in the secondary market can push the price higher, while lower demand may cause the bond to trade at a discount to attract buyers.
- Issuer’s credit profile
If an issuer’s credit rating improves, the bond may trade at a premium. If their financials weaken, the bond price may drop to a discount to compensate for perceived risk.
Note: If you buy a bond and hold it until maturity, these price fluctuations do not impact your returns. You will continue to receive the regular payouts while you hold the bond, and your principal at maturity as promised.
However, if bonds offer fixed returns, why do people keep buying and selling them?
Why Would Anyone Buy or Sell Bonds in the Secondary Market?
The answer lies in how investors use bonds differently, depending on their needs and market expectations.
- Liquidity needs
Not every investor holds a bond until maturity. For example, if you need cash before your bond matures, you have the option to sell it in the secondary market. This allows you to access your money without waiting for the full tenure.
- Opportunity to earn capital gains
Bond prices move based on broader market forces, especially changes in interest rates. When market interest rates fall, existing bonds with higher coupons become more attractive, leading to higher demand and rising prices. Many investors benefit from this by selling their bonds at a higher price, earning capital gains in addition to coupon income.
- Portfolio rebalancing
Experienced investors often adjust their portfolios based on changing financial goals, risk appetite, or market conditions. This could mean selling certain bonds and buying others that better fit their current strategy.
Apart from the above-mentioned metrics, one of the major factors that influence bond investing decisions are the prevailing interest rates in the market.
Bond Price and Interest Rates Relationship
Bond prices and interest rates share an inverse relationship. They move in opposite directions.
- When interest rates rise, bond prices fall
- When interest rates fall, bond prices rise
To understand this, think of it from this perspective.
If you hold a bond that offers 8% returns, and new bonds in the market start offering 10%, your bond becomes less attractive. To sell it, you may have to lower its price.
On the other hand, if your bond offers 10% and new bonds offer only 8%, your bond becomes more valuable. Investors may be willing to pay a higher price for it.
At this point, you must understand that the return you earn from a bond is not just about its coupon, but also about the price at which you buy it. This is what we refer to as a bond’s yield.
Bond Price vs Yield
While the coupon rate of a bond remains fixed, the actual return you earn is captured by its yield.
Yield adjusts based on the price you pay for the bond. In simple words:
- When bond prices fall, yields go up
- When bond prices rise, yields come down
For example, if a bond pays a fixed ₹80 annually (8% on ₹1,000 face value):
- If you buy it at ₹1,000, your return is 8%
- If you buy it at ₹900, your return is higher than 8%
- If you buy it at ₹1,100, your return is lower than 8%
This changing return is what we refer to as yield.
One commonly used measure here is Yield to Maturity (YTM). It represents the total return you can expect if you hold the bond until maturity, considering both the coupon payments and the price at which you purchased it.
Conclusion
By now, Mr. Financewala understands one thing clearly: if he buys a bond and holds it until maturity, the income is predictable.
But most investors don’t always wait for new bond issuances. Most people invest in bonds that are already trading; bonds that have moved or have been repriced.
Which means investors don’t step in at the start, but midway.
And that changes everything.
In the next chapter, we break down how bond yield works in detail, so you can understand what you earn when you buy a bond at any point in time.
