Fixed Income Investments - Pricing Bonds

How bond coupon rates and market rates affect bond price

  • If a bond's coupon rate is above the yield required by the market, the bond will trade above its par value or at a premium. This will occur because investors will be willing to pay up on the bonds price to achieve the additional yield. As investors continue to buy the bond, the yield will decrease until it reaches market equilibrium. Remember that as yield decrease, bond prices rise.
  • If a bond's coupon rate is below the yield required by the market, the bond will trade below its par value or at a discount. This happens because investors will not buy this bond at par when other issues are offering higher coupon rates, so yields will have to increase, which means the bond price will drop in order to induce investors to purchase these bonds. Remember that as yields increase, bond prices fall.

The relationship between the price of a callable bond, an option free bond, and the price of the embedded call option
The price of a callable bond will always be truncated when compared to an option- free bond. This is because a bond with a call option will have a set price at which the bond can be called. An option-free bond does not, and it could trade into higher prices than the stated call price of the embedded option bond.

Example:
You have two bonds that are alike except one of them can be called this year at a price of $102. If market rates decline, the price of both bonds will increase. The option free bond could trade up to $105, however. This is because of the possibility that the callable bond will be called by the issuer and, therefore, it will tend to hold the dollar price at the call price of $102. Why would you buy this bond at $105 when you will only receive $102 if the issuer calls the bond?

The price of the embedded call option will rise when interest rates decrease. This is because as rates decrease, the possibility that the bonds will be called increases, which adds value to the call option. As the price of the call option increases, the dollar price of the callable bond will decrease or be maintained at the call price.

When market rates increase, both issues will tend to decline in value lock step. This is because there will be less of a chance that the bonds will be called; this will make the callable bond act like an option free bond. The price of the option will also decrease, which will also make it trade and be valued more like an option free bond.

Interest Rate Risk of a Floating-Rate Security
Although a floating rate helps to reduce interest-rate risk because of the reset of the rate at periodic times; the price can fluctuate for three reasons:

1. The longer the reset period, the greater the potential price movements will be. The basis is the same as it is for a fixed-rate bond. The longer the time to maturity or the longer to reset, the more market events can affect the price of the bond.

2. The required margin could change. For example, let's say that when an investor originally purchases a bond, the spread over the index that was required by the market was 15 basis points. Because of market events, however, the spread that is required by the market is now 45 basis points. This would cause the floater's price to decline. The opposite would occur if the spread came in to 5 basis points.

3. Floaters usually come with caps. Once this cap value is breached, the reset interest rate can no longer go above a certain level. This will cause it to act much like a fixed-rate security in a rising interest rate environment, meaning the value of the floater will decrease because it can't keep up with current market rates.

Duration


Related Articles
  1. Bonds & Fixed Income

    How To Invest In Corporate Bonds

    Understand the basics of corporate bonds to increase your chances of positive returns.
  2. Bonds & Fixed Income

    Guide To Embedded Options In Bonds

    Investors should be aware of embedded options that may be available in certain securities as these options may affect the value of the security.
  3. Bonds & Fixed Income

    5 Basic Things To Know About Bonds

    Learn these basic terms to breakdown this seemingly complex investment area.
  4. Bonds & Fixed Income

    Advanced Bond Concepts: Yield and Bond Price

    In the last section of this tutorial, we touched on the concept of required yield. In this section we'll explain what this means and take a closer look into how various yields are calculated. ...
  5. Bonds & Fixed Income

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  6. Bonds & Fixed Income

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  7. Bonds & Fixed Income

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  8. Mutual Funds & ETFs

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  9. Bonds & Fixed Income

    Find The Right Bond At The Right Time

    Find out which bonds you should be investing in and when you should be buying them.
  10. Home & Auto

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
RELATED TERMS
  1. Bond Option

    An option contract in which the underlying asset is a bond. Other ...
  2. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  3. Callable Bond

    A bond that can be redeemed by the issuer prior to its maturity. ...
  4. Required Yield

    The return a bond must offer in order to be a worthwhile investment. ...
  5. Bond Discount

    The amount by which the market price of a bond is lower than ...
  6. Call Risk

    The risk, faced by a holder of a callable bond, that a bond issuer ...
RELATED FAQS
  1. Why do companies issue callable bonds?

    Learn how callable bonds work, how they include an embedded call option, and understand the additional risks that callable ... Read Answer >>
  2. What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ... Read Answer >>
  3. What happens to the price of a premium bond as it approaches maturity?

    Learn how bonds trade in regard to premiums and discounts, and how bond prices shift closer to par value as bonds approach ... Read Answer >>
  4. What are the key factors that will cause a bond to trade as a premium bond?

    Learn about the primary factor that can cause bonds to trade at a premium, including how national interest rates affect bond ... Read Answer >>
  5. How does face value differ from the price of a bond?

    Discover how bonds are traded as investment securities and understand the various terms used in bond trading, including par ... Read Answer >>
  6. Should investors focus more on the current yield or face value of a bond?

    Find out when investors should focus on a bond's current yield versus its face value, including an example of how current ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center