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?
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.)
If interest rates do not change a bond's price will actually increase as it approaches maturity. Your 6% coupon becomes more valuable as your bond's maturity shortens. I use an excel rogram to determne the peak value for a bond. In general, selling about a year prior to maturity will give you a nice capital gain.
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.
What role do the bonds play in your overall portfolio? In the case of zero coupons, they are presumably not part of an income producing strategy; are they held to match specific liabilities? Some people will hold zero coupon bonds for the purpose of a specific goal occuring on or about the time of maturity, e.g. college tuition expenses for a dependent.
If the bonds are held as part of a "total return" or "capital gain" seeking strategy, the concept of "exiting basis" or the mark to market yield comes into play.
When an investor first buys a bond, they establish a basis at a specific price and yield to maturity / yield to worst. As time goes by and the price of the bond fluctuates up and down, several things shift economically. Any net change in price versus the original basis creates an unrealized gain or loss opportunity, as well as a new yield to maturity (or yield to worst). For a fixed coupon, non-callable bond (and a zero would qualify as a fixed coupon), a rise in market PRICE would result in a lower yield to maturity, everything else held constant.
Back to your question: the bid side of the market for your bonds will inform your opportunity for a gain in dollar terms; the yield to maturity (or worst) from that new price provides a measure of what you would be giving up in terms of future opportunity. For example, if you bought originally at a 6% yield to maturity, and the price of the bond improved to where the related yield to maturity was 3%, that 3% yield over the remaining term is what you would forgo should you sell the bond now.
An issue that some investors run into in selling their bonds due to a fall in interest rates is one of reinvestment risk; if ALL bonds of a given quality and term experience the same move in price and yield, then selling may present a challenge in finding something suitable to buy, particularly if the bonds serve an income producing role in the portfolio.
I don't believe that looking to trade bonds is the best strategy, here's why:
Bonds are in a tough environment as we speak. Bonds fluctuate mostly with interest rates and the issuer's ability to pay the debt back. They are normally used as a lower risk asset class to complement stocks, but because we are facing increases in historically low interest rates, you have to be vigilant about their use.
I recommend my clients to use a bond ladder to address the problem of increasing interest rates.
1) First, know what your future income need is. By matching a goal to the maturity of a certain bond, you are lowering the risk of selling a bond when it has lost value due to an increase in interest rates. Bonds mature at par (normally $1000). Understanding and planning around this bond feature can reduce your portfolio risk tremendously.
2) Make sure you choose high quality investments. It is tempting to go after high-dividend yields but there is a reason why the issuer has to pay a higher coupon/bigger discount. If we face a recession in the next couple of years, it could mean that the issuer might not be able to pay you back.
3) If you don't need a portion of the money, add a rung to the ladder. This way you should be able to always have constant cash flow from maturing bonds and an opportunity to get more interest income when you reinvest in a rising interest rate period.
I hope this helps.