If you are new to bonds, you might get intimidated by all that you have to learn. Let’s face it; bond investments are laden with a bunch of financial jargon and some strange concepts. These concepts go from how bonds are bought to how they are priced and change over time. But there’s some good news; you don’t have to shy away from a bond investment because you don’t know anything about them yet.
If you put your mind to it, you can learn how bonds are priced and what affects them easily. In this piece, we shall review bond prices and see how you can leverage this knowledge to reduce your risk and improve your chances for a better reward in the long or short run.
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What are Bond Prices?
Now, the price of a bond is a benchmark for a lot of things, including the interest rate and economic forecasts and future interest rates, but even more importantly, it determines how you will manage your investment portfolio and even diversify it. Understanding bond prices and yields will help you invest in any market, including equities.
To understand bond prices, you first have to understand the rules and strategies applied; otherwise, it will all be financial jargon. You can think of it like baseball in the sense that the strategies and basic rules have evolved over time.
So without wasting much time, let’s dive into the bond market price basics.
Classification of the Bond Market
The bond market has a lot of issuers and different types of securities. If we were to talk about all the different types, we’d be here all day. As such, for the purposes of understanding bond prices, we shall zero in on a couple of bond classifications.
- US Treasuries – these are issued by the US Department of Treasury. Yes, with this type, you have to deal with the government
- Corporate bonds – these are bonds that are issued by corporations who conduct investment-grade ratings
- High-yield bonds – these are bonds whose ratings are below the investment grade. They are also known as junk bonds. These bonds come with a high risk of defaulting than those issued by governments and corporations
- Mortgage-backed security – these are investments similar to bonds. They are made up of several home loans that have been bought from banks that issued them. If you invest in an MBS, you will get periodic payments, just like bond coupons.
- Asset-Backed Securities – this is a bond whose collateral is the cash flow of a pool of assets, including credit card receivables, auto loans, aircraft leases, or equity loans. The assets that can work as security for such a bond are many.
- Agency bonds – this is more of debt that a government-sponsored enterprise issue. Such agencies include the Federal Home Loan Banks, Freddie Mac, and Fannie Mae.
- Municipal Bonds – these are bonds issued by the state, the local government, the city, or government agencies.
- Collateralized Debt Obligations – these are asset-backed security backed by either bonds, loans, MBS or ABS or a combination of two or three of these.
How does Bond Pricing Work?
Yield is basically the measure bond experts use to estimate or even determine the estimated return of the bond. In some instances, the yield is also used to measure the relative value between different bond offers. There are two types of yield measures you should understand to have a firm grasp on bond pricing. These include; spot rates and yield to maturity.
Yield to maturity is the return you anticipate from a bond if you hold it to maturity. The calculation is done by considering the interest rate or discount rate that will total the cash flow, total interest, and the current bond price. Like bonds, there are different types of current prices. These include the current price in the bond market, in over the counter trades, and in retail sales.
Back to yield-to-maturity calculation, the math makes two assumptions;
- You will hold the bond until it matures
- The cash flows from the bond are reinvested at the specified yield until the bond matures
On the other hand, spot rate calculation deals with the interest rate, which means the current value of zero-coupon bonds are equal to the bond price. Several spot rates should be calculated to price a coupon bond.
First, what is a benchmark? Simple, it is a standard with which bonds or other investments are measured. Every bond on the market is priced in relation to a specific benchmark. The reason we mentioned the different types of bonds is for this section. All types of bond classifications have different price benchmarks and, different prices.
Some common bond pricing benchmarks include the on-the-run US Treasury. Most issuers price bonds relative to some treasury bonds. For instance, an on-the-run ten-year treasury bond might be used to set a benchmark bond price for a different 10-year corporate bond.
On occasions when the maturity of the bond isn’t clear or exact because of put or pull features, a benchmark curve is used to price the bonds. This is done because most often than not, maturity estimates or put-able or callable bonds don’t coincide with exact the maturity of treasury bonds.
So how are the benchmark pricing curves made? Bond experts use yields of some underlying securities that have maturities ranging from 3 months to 30 years. Moreover, different benchmark securities or interest rates are used to construct the benchmark pricing curve. Since there are gaps in the maturities used in constructing the curve, the yields are interpolated between the observable yields.
As mentioned, the most common benchmark curve used in the industry is the on-the-run US treasury curve. This curve is constructed using US Treasury bonds, bills, and notes. Since these bonds are only provided by the US Treasury and have three months, six months, two years, three years, five years 10, and 30 years of maturities, all the theoretical bonds that have maturities between the given maturities are interpolated. The resulting curve is called an interpolated yield curve.
Other popular bond benchmark pricing curves include;
- The swap curve – this curve is made using fixed interest rates of interest swaps
- Eurodollars curve – this curve is constructed using interest rates gotten from the future pricing of Eurodollar
- Agency curve – the curve is made with yields of fixed non-callable agency debts
- Spot rate treasury curve – this is made by using theoretical spot rates from the US treasuries
Yield spread for the bonds
A bond yield that is relative to the yield of the resulting benchmark is known as a spread. A spread is used to determine the relative value between bonds as well as a way of pricing bonds. You can think of the spread like the difference between the two bonds.
For instance, you might come across a corporate bond trading at a spread of 55 basis points above a ten-year treasury bond. What this means is that the bond’s yield-to-maturity of the bond is 0.55% higher than the yield-to-maturity of the on-the-run treasury lasting ten years.
If you came across a corporate bond that has a similar credit rating, duration, and outlook, but with a spread of 90 basis points, then this would be a better investment in comparison to the former example.
There are a couple of spread calculations you can use with the different bond pricing benchmarks. However, the main four calculations include;
- Nominal yield spread – this is the difference between the yield-to-maturity of a bond with the yield to maturity of the bond’s benchmark
- Z-spread – this is a constant spread which when you add to the yield at every point of a spot rate treasury curve, yields a security price equal to the present value of the bond’s cash flow
- OAS (Option-Adjusted Spread) – this type of spread comes in handy when evaluating embedded options, including put-able and callable bonds. It is the same as the Z-spread only that the spot rate curve is calculated using multiple interest rates. Simply put, each spot rate curve is calculated, and a mean is calculated for the interest rates. The OAS accounts for the volatility of the interest rates as well as the possibility of prepayment of the principal value.
- Discount margin – bonds that have variable interest rates have their prices sloe to the par value. This is because the interest rates and coupons with these bonds adjust to the interest rates depending on the reference rate. If you add the DM spread to the current reference rate, the bond cash flow will be equal to the current bond price.
Now let’s match the different bond types to their benchmark and spread calculations
- High-yield bonds – their bond prices are calculated with the nominal yield spread to on-the-run US Treasury bonds, but from time to time, when the outlook and credit of the bond takes a dip, the bond will trade at the actual dollar price.
- Corporate bonds – these bonds are also priced at nominal yield spread relative to the on-the-run US treasury bonds, which match its maturity. For instance, a five-year corporate bond will always be priced relative to the 5-year treasury and not the 3-year or ten-year treasury.
- Mortgage-backed securities – there are lots of MBS. Most of these trade at a nominal yield spread at their average to the US treasury L-curve. On the other hand, the adjustable MBS trade at Discount margin while others trade at the Z-spread.
- Asset-backed securities – the ABS frequently trade at nominal yield spread at their average to the bond swap curve.
- Agencies – these usually trade at the nominal yield spread at specific treasuries, including the on-the-run 10-year treasury.
- Municipal bonds – given the tax advantages of municipal bonds, the yields aren’t correlated with US treasury yields, as is the case with most bonds. As such, municipal bonds trade at the dollar price or the yield-to-maturity.
- Collateralized Debt Obligations – like the ABS and the MBS, which usually back CDOs, there are several benchmark pricings and yields used to arrive at the price of CDOs. From time to time, the Eurodollar curve is used as the main benchmark.
Though the bond pricing rules can be tricky, the above are simple rules that can help you have a firm grasp on the bond price and what affects them.
Now, from the basics above, one fact stands out; yield to maturity affects the price of a bond, but is this the only factor affecting the bond price? Of course not. In the next section, we shall look at the other characteristics used to calculate the bond price.
Bond Price Characteristics
The bond price depends on several characteristics including;
- Yield to maturity
- The principal or par value
- Periods to maturity
Bonds can either come attached or not attached to coupons. A coupon is the nominal percentage of the principal bond amount payable every year. For instance, a 10% coupon on a $1,000 bond is redeemable every year. Some bonds also come with no coupons; these are called zero-bond coupons and such bonds have a lower price in comparison to coupon bonds.
Every bond comes with a principal value that is given back at bond maturity. Without this amount, the bond would be useless. The principal value is repaid to you by the bond issuer. Though zero-coupon bonds don’t come with yearly coupons, they do have a principal at the maturity period. If you purchase a zero-coupon bond, you will make a profit by buying the bonds at a discount.
Yield to maturity
Every bond is priced in such a way that it will give a return to its investor. Bonds that sell at a premium always have low coupon rates.
Period to maturity
Different bonds have different periods to maturity; some have annual periods, and some have quarterly or annual periods. The number of periods will be the same as the number of coupons paid.
Time Value of money
A bond is priced depending on the time value of money at the time. Every payment is discounted to the prevailing time based of the yield to maturity. The bond price is often calculated by;
P(T0) = [PMT(T1) / (1 + r)^1] + [PMT(T2) / (1 + r)^2] … [(PMT(Tn) + FV) / (1 + r)^n]
In the above calculations;
- P(T0) – the price at time 0
- PMT(Tn) – the coupon payment at the time N
- FV – future value, principal value
- R – yield to maturity
- N – the number of periods
Main Characteristics of a Bond
If all factors are held constant, then:
- A bond that has a high coupon rate will fetch a higher price as well
- A bond that has high principal value will be highly-priced
- A bond that has more periods to maturity will have a high price
- A bond that has a high yield to maturity will have a higher price as well
Other characteristics of bond pricing include:
The below characteristics affect the price of a bond in secondary markets.
- The creditworthiness of the issuer
- Liquidity of the bond
- Time to the next payment
The creditworthiness of the issuer
Bonds are aways rated depending on the creditworthiness of the issuer. You can think of a bond like a loan. In this case, the issuer is the borrower, and you are the lender. The price of the bond will, therefore, depend on whether the issuer (borrower) can pay coupons. The issuer ratings range from AAA (excellent) to D (bad). Bonds with high ratings are low risk and, therefore, good bonds to invest in while those with lower ratings are known as junk bonds and have higher risks. Junk bonds have a high yield to maturity, which compensates for their high risk. Also, because of this, junk bonds fetch a lower price.
Bonds that trade wide in the markets have more value than those that are sparsely traded. Generally and the investor will buy a bond that they can sell off faster in the new future. As a result, the price of illiquid bonds plummet.
Time to payment
The time remaining to your next coupon payment can actually affect the bond price. Admittedly, there are some complicated calculations and theories that go into determining this. Experts refer to it as dirty pricing. The process considers the interest that adds up between the payments. As the payment date draws near, a bondholder will wait for a lesser time before they receive their payment. As you get closer to the payment, the price increases steadily before dropping again after coupon payment.
Generally, when inflation is higher, the bond price will fall. When inflation reduces, the bond prices rise. The two are indirectly proportional. It is so because an increase in inflation steals the buying power of what you will earn from the investment over time. Simply put, at bond maturity, the return earned on the bond investment will be worth less than what it is worth today.
Like with inflation, when the interest rate rises, the bond prices plummet. And when the interest rates fall, the bond price shoots through the roof. For instance, if you own a 3% interest bond, and the interest rates are low, say at 1% (the interest rate is higher than the purchase rate), the bond will be attractive to investors. However, if the opposite is true, where the interest rate rises to 5%, then the bond becomes unattractive to investors.
The bond price is an important consideration. You should make a point of learning the basics above and taking another step to learn how to use the knowledge to your advantage in managing bonds. Remember, knowledge is power, and this piece will help you earn more money too. If you are looking to start bond investments, you should consider bond brokers based in the US.
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Is there a relationship between bond price and interest rates?
Yes, there is. The two are inversely correlated. This means that when the interest rates take a dip, the bond prices soar. And when the interest rates rise, the bond price increases. But if you purchase a bond and then hold it until maturity, then an increase in the interest rates will not affect the principal amount that you get at maturity.
Can I gain from a bond investment?
Yes, you can. There is a reason it is called investment, after all. You can enjoy regular income in the form of bonds. Moreover, including bonds in your investment will also diversify the risk.
Is there a minimum period I can invest with bonds?
No, there isn’t. Bond investment is thought of as long, medium, and short term. You can either hold the bond until maturity (long term investment) or withdraw the amount before maturity.
Will my bond investment give me a guaranteed return?
No, it will not. Bonds are subject to several factors, as explained in the guide, including creditworthiness, interest rate, and yield to maturity. These factors collectively determine what you stand to gain from the investment.
Can I buy bonds online?
Yes, you can. There are many bond brokers you can use to achieve this.
Is there a risk in bond investment?
Like any investment, bonds have risks as well. Some bonds have high risks, and others have lower risks. If it were free of risks, many would have made it big with bond portfolios, right?