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Most of us are familiar with stocks. Major news channels display live or near-live prices of stocks, the level of major indices is front page news, and people gauge the health of the economy by the level of stock and indices. However, the bulk of the capital of companies is not in stocks, but rather in bonds. We don't see these prices, apart perhaps for major government bonds. Yet, if there is so much money locked up in them, they must be important, right?

The subprime crisis is a clear example of the importance of bond prices. banks, insurance companies and pension funds invested in bonds that were backed by mortgages. It turned out that many of the people holding these mortgages could never pay them. Furthermore, the houses backing the mortgages dropped sharply in value. This caused the prices of bonds to drop, leaving the people holding them with massive losses.

So, what does determine the value of a bond. The easy answer would be "The expected future payout", just as for a stock. However, the cardinal difference is that this future payout may be known a lot more precisely for a bond than for a stock. Specifically, a bond gives the owner the right to collect interest; for a stock, there is the possibility of an uncertain dividend. In principle, five variables determine the value of a bond: its principal, its interest rate, the chance of default, duration and supply and demand.

The principal is the sum over which the interest is computed, and the amount of money that will be paid when the bond is paid back. The value of a bond is linear in its principal. Note that when I buy a bond for less than the value of the principal, I will make money when the bond is paid back in full; this increases the yield of the bond. Conversely, buying a bond for more than its principal decreases the yield. In the case of a zero-coupon bond, the only money paid is the principal in the end; there is no interest.

Secondly, having a bond means you get interest. The higher the interest is compared to the interest on a similar bond, the more valuable the bond. This has a very important consequence. If I hold a bond, and the interest rate drops, my bond becomes more expensive. The reason is that I still get the old, higher interest rate, while other people getting a similar bond now get less interest rate, This has the somewhat paradoxical effect that even though the interest on my bond is fixed, I am still exposed to interest rate changes. You might argue that this is not real money, as you won't be getting more money in total by holding the bond until maturity. This is in principle correct; the "profit" is in the fact you didn't buy the bond at a later time and didn't lose money on that/made less money. However, by mark-to-market accounting, the gain or loss on the bond is realized immediately. This is especially appropriate if the bond is financed by borrowing money; the cost of borrowing goes down, while the interest received remains the same; this will lead to a profit. Conversely, if the interest rate goes up, the holder of the bond loses money.

The third factor influencing the value of a bond is the chance of default. If there is a significant chance the debtor won't pay you back, the value of the bond drops. Note that unlike interest and principal, this is not something that can be measured exactly. This means that if a bond price changes, and it's not because of interest, it may be the chance of default. The chance of default for a bond may be reflected by its credit rating. However, after the massive failure of rating agencies to rate structured subprime bonds, the value of these ratings has gone down quite a bit.

An important yardstick in measuring the chance of default is the government bond. You see, conventional wisdom holds that a government can always pay back a bond in its own currency. This means there is no chance of default. Should a government "default", the likely result is that it will print massive amount of money to pay back its bonds. Hence, the value of the money itself disappears, but the bond will be paid back.

For companies that are in distress, the value of bonds may drop rapidly. This means that they cannot get funding at an acceptable rate, worsening the problem. It is noted that the holders of bonds do get a slice of the proceeds when a company is liquidated; this rarely pays for the whole bond. Any excess will be distributed among the shareholders, but this is an exceedingly rare situation.

The fourth factor is the duration of the bond. The longer the maturity of the bond, the more interest is received and the more important the risk of default. For short-dated bonds, the risk is proportional to the duration, although this effect saturates for very long-dated bonds (typically 5-15 years). The reason is that for short-dated bonds, the payback of the principal is the main cash flow, and the chance of default is normally small, provided the company (or other issuer) issuing the bond is reasonably healthy. For longer-dated bonds, there are many interest payments. Furthermore, these interest payments are done earlier than the payback of the principal. These interest payments could be reinvested, and these reinvested interest payments could be more valuable than the principal. Furthermore, the health of the issurer may deteriorate, or improve; it is difficult to predict this for very long-dated bonds. It is noted that typically, investors are compensated for this increased risk by a higher interest rate on longer-dated bonds.

The fifth and most random factor is supply and demand. Even though we might fairly rationally price a bond, there is a matter of supply and demand that can monetarily change the prices of bonds. In this respect, they behave just like stocks. Especially during a crash or crisis, this factor can be quite large. Typically, in this case, the price of government bond goes up, while the price of bonds issued by companies goes down.

By taking these four factors - principal, interest, default risk, duration - and allowing for a correction for supply and demand, we can in principle rationally price a bond. In practice, the main drivers for a bond price are interest rate changes, and default chance. For people investing in government bonds, especially interest rate changes are important.

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