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?
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®
A zero coupon bond is sold at less than face value and redeemed at face value when it matures. The difference between the discounted price and face value is intended to be the return on investment. If you buy the zero coupon bond at the initial offering and hold it until maturity, you will get the stated 6% return on investment.
But there are several other possibilities. If you bought the bond at a price lower than the initial offering price and held until maturity, you would get a return greater than 6%. And vice-versa.
If you don't hold until maturity, the situation can change significantly. When interest rates go down, the prices of bonds go up. When interest rates go up, the prices of bonds go down. So in simple terms, the best time to sell bonds (assuming that maturity is still a while off) is when interest rates are lowest. At the current time, interest rates have risen from their recent lows and will be rising further in the future. The bonds with the longest maturities will be the most sensitive to changes in interest rates.
The price of a bond is inversely related to the market interest rates. If rates fall and the value of the bond has gone up a lot and you think you can get a better yield to maturity for a comparable bond, then you would sell your bond and buy the other bond.
You would also sell your bond if the creditworthiness of the issuer is in question and you think the price of the bonds you hold will fall.
A zero-coupon bond does not pay periodic interest but is sold at a discount to face value (which you get at maturity). Zero coupon bonds are extremely sensitive to interest rates (High duration) and if the price has appreciated a lot you would replace it with a comparable bond with higher yield.
(This is the most basic explanation- there are several other complex strategies that may need bonds to be sold for a variety of reasons.)
Bond prices and interest rates work like a see-saw at a playground, prices on one side and interest rates on the other. When interest rates go down, prices go up, and visa-versa. The longer the maturity of the bond, the more it is like sitting at the end of the board on the see-saw, which means more ups and downs in the bond's price.
With zero-coupon bonds paying no interest income between purchase date and maturity, all else being equal, they have the most price volatility due to changes in interest rates. That can be good or bad depending on which way interest rates are moving.
If you have invested to meet a future liability, then price volatility may not be that big of a deal. If you have invested for total rate of return, it is. The sell or not to sell question depends on when the bond will mature, the future shape of the yield curve, and what alternatives you have or will have for the proceeds.
The price of a bond and interest rates have an inverse relationship. If rates go up the price of the bond goes down and vice versa. There are two risks associated with individual bonds: interest rate risk and default risk.
- Interest rate risk: If you hold your bond to maturity interest rate risk will not be a concern. Although if it is a long term bond and you find yourself needing the cash then you may have to sell at a loss if interest rates have gone up from the time the bond was purchased. Conversely, if interest rates have gone down since you bought your bond then that could create an opportune time to sell your bond and take the appreciation in the price of the bond as well as the income you have already received. You would want to do the math to see if it makes since to sell versus collecting the remaining income on the bond. Also, if rates are lower where will you reinvest those funds to get a similar yield.
- Default risk: This has to do with the quality of the issuer and/or if the bond is insured. If your issuer defaults on the bond by not making the payments then the price will certainly be reflected and you could lose most or all of your principal.
So the best time to sell a bond versus letting it mature, would be if rates have gone down from the time it was purchased and this will be enhanced if it is a long term bond.