Introduction to bond pricing

Bonds can be priced at a premium, discount or at par. A bond is at a premium when price of the bond is higher than its par value and at discount when price of the bond is lower than its par value. With rates, when the bond yield is lower than the coupon rate, the bond is selling at a premium, and selling at a discount when the bond yield is higher than the coupon rate.

Traditionally, a bond is issued at par or face value, which represents the amount the issuer promises to pay back to the investor at maturity of the bond.

The price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity.

Bond price is quoted in percentage of the par value (100); value of 95 implies 95% of par value, as value of 110 implies 110% of par value. A bond issued with par value of 100 could have a yield of 14% if the coupon rate at issue is 14%.

On the other hand, a bond issued with a discount (less than par value of 100) will have no coupon rate but have a yield of 14%. The price of a bond and its yield are inversely related. When price of a bond falls, the yield of the bond rises.

If the price of a bond drops to 97.50 from 100 par value, yield on the bond will rise to above 14% depending on the term to maturity of the bond. The higher the term to maturity, the higher the bond yield.

While prices of bonds are majorly affected by the demand and supply of the bonds, there are also other factors to be considered when making trading/investment decisions in these securities:

Interest Rates

In general, when interest rates rise, bond prices fall and vice versa. This implies an inverse relationship between interest rates and bond prices. If an investor buys a bond at par value of 100 at 14% while interest rate is 12%, the investment will be regarded attractive because of the higher yield on investment. If the general interest rate rises to 14.5%, the bond at 14% would be deemed unattractive as rate of return on investment is lower than interest rate. In this latter scenario, investors will most likely make adjustments for this by seeking higher yields thereby making bond prices fall and yields on the bonds rise. This will make the bond competitive

Inflation

When inflation is on the rise, bond prices fall. When inflation is decreasing, bond prices rise. This is because rising inflation erodes the purchasing power of what is earned on an investment. In other words, when a bond matures and inflation is on the rise, the return earned on investment will be worth less.

Exchange Rate

Exchange rates affect bond prices because a devaluation could lead to increasing interest rates while a revaluation could reduce interest rates.

Credit Ratings

A credit rating can provide information about an issuer’s ability to make interest payments and repay the principal on a bond. The higher the credit rating, the more likely the bond issuer is to meet its payment obligations. If the issuer’s credit rating goes up, the prices of its bonds will rise and a reduced credit rating will drive the prices of their issued bonds downwards.