Basics of Bond Pricing

Basics of Bond Pricing

Before you can begin to understand why bonds are traded at different prices on the secondary market, you will need to know some basic definitions.

What is a bond?

A bond is a certificate of debt sold to raise capital. When you buy a bond, you are lending your money to a business or government. The bond issuer (seller) promises to repay you the original amount of the bond (the principal) at a specific future date. The time when the bond is scheduled to be paid back is known as the bond’s maturity date.

The face value of a bond is known as its par. A bond’s par is the same as its issue price and the price to be repaid when the bond matures (reaches its maturity date).

Bonds also earn interest. The rate at which a bond earns interest on its par is known as its coupon rate.

Measuring the return

The amount of return you make on a bond is measured by its yield-to-maturity (YTM). Yield-to-maturity is the total amount of interest on a bond over its entire lifespan. It tells you how much you will make on the bond if you hold it until maturity or until it is called (bought back). A bond’s yield-to-maturity includes any interest on the bond’s coupon rate as well as any loss or gain from buying the bond above or below its face value. The calculation for YTM is based on a bond’s coupon rate, time to maturity, and market price. Although the exact calculation is tedious, there is a simple approximation you can use to calculate the yield-to-maturity.

Where:

    I = the annual interest (in dollars)

    P_b = bond market price

    n = number of years to maturity

For example, imagine a bond with a 10 percent coupon that pays $100 per year interest, is selling for $1,100, and has five years to maturity. Its yield-to-maturity is approximately:

It’s because of the yield-to-maturity that bonds trade on the secondary market at prices different from the par or face amount.