What does the Market Price of a Bond Depend On?
A bond is a type of fixed-income investment instrument, that refers to a loan made by an investor to the borrower. The issuer of the bond (borrower) is typically a corporate or government organization. Corporate companies, or governments issue units of debt to raise funds, treating them as securitized tradeable assets.
A bond can be considered as an I.O.U between the lender and the borrower and includes details such as the loan and its payment structure. They are commonly used by companies, municipalities, states, and sovereign governments as a means to finance projects and operations. Bond owners are debtholders or creditors of the issuer.
What factors affect a bond's market price?
The pricing of a bond is considered to be an empirical matter in the field of financial instruments. The pricing of the bond depends on several characteristics that are inherent to every bond issued. These characteristics include:
- The coupon offered or the lack of it
- The bond principal or the par value
- The yield to maturity
- The time duration to the period of maturity
Bond prices like any other publicly traded security, change daily, depending on the supply and demand, which at any given moment determine the observed price. The price of the bond also changes in response to the changes in the interest rates in the economy. As for fixed-rate investment security, for bonds offering a fixed coupon, in scenarios of rising interest rates, investors are not inclined towards buying bonds, causing a decline in the demand and subsequently a decline in the bond prices.
Consequently, with the interest rates in the economy dropping, bonds with a fixed rate coupon are popular among investors, causing their prices to rise. The difference in the interest rate makes the bonds attractive to the investors, who bid up to the price of the bond until it trades at a premium.
Types of Pricing
-
Bond pricing by coupons
A bond may or may not offer any coupon. A coupon is a nominal percentage of the par value, which is the principal value of the bond. Each coupon is redeemable per period for that percentage. Zero-coupon bonds are bonds that come with no coupon. They are typically priced lower than bonds that offer coupons.
-
Bond pricing at par value
The principal or the par value of the bond is the amount that is repaid at maturity. The principal value of the bond is to be repaid to the lender (the bond purchaser) by the borrower (the bond issuer). With a zero-coupon bond, no coupons are paid but the repaying of the principal is guaranteed at maturity. Investors of the zero-coupon bond, earn interest by the bond being sold at a discounted par value. A bond bearing a coupon pays a coupon each period and a coupon in addition to the principal at maturity. The bond price comprises all the coupon payments discounted at the YTM.
-
Bond Pricing at Yield to Maturity
The pricing of the bond is done in a manner such that it yields a certain return to investors. Bonds that sell at a premium, that is their market price is above the par value, will have a YTM lower than the coupon rate. Alternatively, the casualty of the relationship between a bond’s YTM and its price may be reversed. A bond with an intended yield (market interest rate) lower than the coupon may also be sold at a higher price, provided the bondholder receives coupon payments that are higher than the market interest rates and therefore can pay a premium for the earned difference in returns.
-
Bond Pricing by Periods to Maturity
The period to maturity is a characteristic of every bond. They are typically issued for annual periods, but may also have a semi-annual or quarterly period to maturity. The number of periods is equivalent to the number of coupon payments received by the investor.
How are Bond Prices Calculated
The pricing of the bond is based on the concept of the time value of money. With every payment discounted to the current time based on the yield to maturity, also market interest rate. How bonds are priced is usually through the formula as follows:
P(T0) = [PMT(T1) / (1 + r)^1] + [PMT(T2) / (1 + r)^2] … [(PMT(Tn) + FV) / (1 + r)^n]
Where:
P(T0) = Price at Time 0
PMT(Tn) = Coupon Payment at Time N
FV = Future Value, Par Value, Principal Value
R = Yield to Maturity, Market Interest Rates
N = Number of Periods
Related Articles
Frequently Asked Questions
For all other factors held equal,
- A bond with a higher coupon rate will be of a higher price
- A bond with a higher par value will be priced higher
- A bond with a greater number of periods to maturity will be of a higher price
- A bond with a higher YTM or market rate will be priced lower.
These are empirical characteristics that affect the issue of a bond, especially in the primary market. In the secondary market, however, factors such as the creditworthiness of the firm issuing the bond, the liquidity of the bond trade in the market, and the time till the next coupon payment are all considerable bond characteristics that can affect the bond pricing.