When should you sell a bond?

I'm learning about bonds. Why would someone sell their bond if they are holding a zero coupon bond and it generates a 6% return on maturity? I'm currently holding those. I was reading that people sell their bonds when interest rates go down because they can get more than what they paid. When is the most opportune time to sell a bond?

Bonds / Fixed Income
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December 2016
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In the current environment, the time to sell a bond was a few months ago as interest rates are now rising. The long term trend of dropping interest rates, and therefore bull market in bonds, may be over. This is if you are active and looking for capital gains and best price. If you are happy with the 6% and not worried about inflation, especially if you have a specific use for the funds to cover, then you may consider holding.

Bonds are usually denominated in $1,000 increments known as face value or par. This is the price you receive per bond when they mature. Bond prices move inversely with interest rates as to set them to the "effective" interest rates in the economy. So, when a company issues a bond, they attempt to set the stated or coupon rate on the bond at the current market, which is know as the "effective" rate in the economy for the same risk level of that particular bond - investment grade, junk, etc. By the time they get the bond issued, interest rates may have moved from that rate. For example, if the stated rate (coupon) on a bond is 6%, and the going rate in the economy (effective) is 4%, isn't your bond worth more than "par" or $1,000/bond. Thus, it will sell at a premium to the seller, but effectively sets the yield to maturity (YTM) at 4% for the buyer. If market rates are 8%, then your 6% bond will sell at a discount, thus setting the YTM for the buyer at the current market rate of 8% because he paid less than face value (par) for the bond.

The old joke in the industry is what is the difference between a new 5%, 10 year bond and a 5%, 20 year bond with 10 years left to maturity? The answer is nothing, assuming the same quality. This is why existing bonds must be sold at a discount or premium to par as stated above to compete with newly issued bonds. It is the pricing mechanism to set bonds to current conditions. 

The two things that adversely affect bond prices are rising interest rates and inflation. Rising rates makes your bonds less competitive and inflation erodes purchasing power. Either will drive bond prices down. And if we have high inflation, bond prices can easily go down by double digits. So, the risk profile of bonds, like stocks, changes over time. You have been told that it is all about your risk tolerance, but I humbly disagree. I believe it is more about the risk in the asset or sector itself which is more important. People's risk tolerance and behavior changes over time. When the market sells off, they become scared and defensive, and when the market is rallying, they become more aggressive. I am not saying this is a logical behavior, but it just is.

The point is that if you are trying to offset a specific liability for your zero coupon bond, known as asset liability matching, then that is fine. But if you are tying to maximize your wealth by not holding assets that are more risky at times, then the risk in bonds is currently elevated. Longer term bonds are more sensitive to interest rates because you have more uncertainty and longer to hold. Zero coupon bonds are even more sensitive because you don't get any interest payments, or coupons, to reinvest at higher rates and offset.

I answered your question a little technical, but you said you were trying to learn. And I used bond terminology so you could research. Bonds can be as complicated as stocks in certain environments. We may be entering one of those periods now. Just an FYI, long term treasury bonds were long over -30% during the late 70s when we had high inflation. I am not trying to scare you our imply this is imminent, but bonds can and do lose lots of money under the right circumstances.

I do not believe the Fed can raise rates with any seriousness without crushing the economy, so I think they will do one or two small token moves (my opinion). But inflation is even more insidious for bonds, so you need to pay careful attention for signs of inflation.

Sorry this was so long winded, but hopefully it will give you something to think about & research. Happy Holidays, Dan Stewart CFA®

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December 2016
December 2016
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