how bonds are priced

In the previous article I have written in detail about how bonds work and how to buy bonds. Many people requested me to write about how bonds are priced.

Bonds are a borrowing tool through which bond issuers borrow from lenders. Generally we know the most common way to get a loan is to go to a lender and apply for a loan. But in case of bond it is different. Bonds issuers take loans in exchange for securities. For this the investor are paid a certain rate of interest. In case of maturity of the bond, the full value of the bond has to be paid to the investor.

The initial value of the bond is called the face value. When an underwriter announces the release of a bond, the price at which they sell it is the face value of the bond. But later when the bonds are traded in the open market, the value of the bonds fluctuates time to time.

How are Bonds Priced?

Bonds are debt instruments through which bond issuers raise funds from investors. It can also be called a loan.

Bond transactions are different than stocks. The value of bonds does not increase in the same way as the value of stocks or mutual funds increases in the market. Other factors work here.

The value of the bond is called face value or par value. The investor pays face value to the bond issuer when purchasing the bond.

Bond interest rates are usually fixed. Interest is paid to the investor at a certain time every year till the maturity of the bond. However, bonds are also issued at variable interest rates. In this case the interest will increase or decrease depending on the current value of the bond.

Bond prices depend on three different influencers.

  1. Supply and Demand
  2. Maturity of Bonds
  3. Credit Quality of Company

Supply and Demand

There is a general rule of thumb in the economy that when the supply of a commodity is high then the demand goes down, when the demand goes down the price also goes down. Again, when supply decreases, demand increases, which in turn increases prices. Bonds market follows the same rule. Bond prices fluctuate depending on supply and demand in the market.

Bonds are issued at face value or par value. When the bond is traded at a price higher than the face value, it is considered as a premium price. For example, the face value of the bond is $1,500 but it is sold at premium price for $1,700.

When it is sold at a price lower than face value, it is called a discount bond. For example, a $1,500 bond sold for $1,300.

Since the interest rate on the bond is fixed, the lower the value of the bond, the higher the yield on the bond. Suppose the face value of a bond is $1000 with a coupon rate of 5% then you get $50 per year as interest But if the face value of the bond goes down to $800, you will still get $50 interest. That means you are getting 6.25% more yield.

Maturity of Bonds

The maturity of the bond means the lifetime of the bond. The term of the bond is usually 10 years. However, some bonds may have higher or shorter maturity.

Bonds with higher maturity have higher interest rates and lower prices. Because long-term bonds carry some risks. Such as bond issuers may fail to pay interest at the right time. Again, it is possible the financial condition of the company may go down and firms to default.

The shorter the maturity of the bond, the lower the interest rate and the higher the price of the bond. This is because short-term bonds are much less likely to default.

Credit Quality of Company

The credit quality of the company has huge influence on the pricing of the bonds. When you go to buy bonds from the bond market, you will see that the bonds of the companies whose credit rating is poor are much lower and the interest rates are higher. Since the default risk of these bonds is high, they provide these benefits to attract investors.

On the other hand, companies with very good credit ratings offer lower bond prices and lower interest rates. Because the default risk of these companies is much less. So investors are always more interested in investing in these bonds. So the company does not need to give any incentive to sell their bonds.

Take a look at credit ratings:

how bonds are priced
Photo – Forbes

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