Bonds' Pricing in the Secondary Market

Impact of Variation in Market Interest Rate Environment on Bond Market Value

If one holds a total of 1,000 bonds ($1 million capital investment value) issued by a company and the bond carries a coupon rate (interest rate) of 5 percent, this means that this investor would derive annually $1 million multiplied by 5 percent or $50,000. Suppose the market has changed and interest rates have, for one reason or another, increased to 10 percent. If the same company goes to the market to issue new bonds it will have to mark the coupon interest rate higher to 10 percent. That is if one invests $1 million in the new bonds then the investor would expect to derive an interest income of $100,000. This amount of interest income is double the amount received from the first bond issue with a 5 percent coupon. If one goes with the 5 percent coupon bonds to the secondary market to sell them and create cash, then the buyer will reason that if he invests in any of the new bonds in this 10 percent environment his income will be 10 percent or for a $1 million annual income should be at least $100,000. That is, in order for the holder to sell the 5 percent bonds and for the buyer to produce an income of $100,000, it must sell for a value of $500,000. This new value is derived simply and in general by dividing the perceived interest income of $50,000 obtained from the 5 percent bonds by the $100,000 that can be received from the new 10 percent bonds. If one multiplies the result or 0.5 by $1 million, this produces the new value of the 5 percent bond on the market and the resulting fair calculated value would be $500,000. That is, due to the increase of interest rates in the market from 5 to 10 percent, the value of the 5 percent bond declines by 50 percent. Such a decline has an effect on the value of the bond in the market in case its holder wants to sell these bonds for cash. Of course, there are other factors in the market that may change that price to an even lower value or a higher value. However, if the company, the government or the entity that issued these bonds is still in a good operating and financial condition and can pay back the bondholders at maturity, they will be paid the face value or $1,000 a bond at maturity date. That is why market players try to buy bonds at a discount in order to earn a handsome capital gain at maturity. This occurs especially in the case of sovereign government bonds when some of these bonds sell at deep discount at 10 percent of face value or even at a much deeper discount due to political, economic, social, or environmental instability. High-risk investors gamble by assuming and projecting that these particular governments will not risk their market creditworthiness at maturity and will pay the full face value, resulting in a huge profit windfall for the investor.

Liquidity of Bonds

As discussed earlier, investors are most concerned about the creditworthiness of the entity that they will invest in either in the form of equity or in the form of fixed-income securities (bonds in general). The question is: if we own shares or bonds in this entity can we readily go to the market, sell them, and receive cash? This is called market liquidity. This market liquidity is defined by the size and liquid capacity of the secondary markets. Such liquidity is enhanced by having market makers who facilitate the functioning of the market and act as a catalyst to encourage buyers and sellers to participate in the market.

It is worth noting that the RF bond (sukuk) markets are still thin and are not readily liquid. The Malaysian capital market officials are doing their best to enhance the liquidity of the sukuk in the Malaysian market, which is the largest sukuk market in the world.

 
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