Investors should become familiar with bond pricing conventions. Bonds do not trade like stocks. The pricing mechanisms that cause changes in the bond market seem not nearly as intuitive as seeing a stock or mutual fund rise in value. That’s because equities trade on a value based on what they are expected to be worth in the future (based on potential earnings growth).
- The three primary influences on bond pricing on the open market are supply and demand, term to maturity, and credit quality.
- Bonds that are priced lower have higher yields.
- Investors should also be aware of the impact that a call feature has on bond prices.
Bonds trade based on stated contractual cash-flows (a known series of interest and principal return). In other words, a bond’s attractiveness in the market is based on two key risk factors. The first is the interest rate it pays relative to a similar bond issued at today’s rates—interest rate risk. The second is whether or not the issuer still has the ability to make the scheduled payments on those pre-determined dates and at maturity—credit risk.
Each bond has a par value, and it can either trade at par, a premium, or a discount. The amount of interest paid on a bond is fixed. However, its current yield—the annual interest relative to the current market price—fluctuates as the bond's price changes.
The price of a bond is determined by discounting the expected cash flows to the present using a discount rate. The three primary influences on bond pricing on the open market are term to maturity, credit quality, and supply and demand.
Bonds are issued with a set face value and trade at par when the current price is equal to the face value. Bonds trade at a premium when the current price is higher than the face value. For example, a $1,000 face value bond selling at $1,200 is trading at a premium. Discount bonds are the opposite, selling for lower than the listed face value.
Since the interest paid on bonds is fixed, bonds that are priced lower have higher yields. They are more attractive to investors, all other things being equal. For instance, a $1,000 face value bond with a 6% interest rate pays $60 in annual interest every year regardless of the current trading price. Interest payments are fixed. When the bond is currently trading at $800, that $60 interest payment creates a present yield of 7.5%. Supply and demand can influence the prices of all assets, including bonds.
Bonds with higher yields and lower prices usually have lower prices for a reason. These high-yield bonds are priced with higher yields to reflect their higher risks.
Term to Maturity
The age of a bond relative to its maturity has a significant effect on pricing. Bonds are typically paid in full when they mature, although some may be called and others default. Since a bondholder is closer to receiving the face value as the maturity date approaches, the bond's price moves toward par as it ages.
When the yield curve is normal, bonds with longer terms to maturity have higher interest rates and lower prices. The main reason is that a longer-term to maturity increases interest rate risk. Bonds with longer terms to maturity also have higher default risk because there is more time for credit quality to decline and firms to default.
The overall credit quality of a bond issuer has a substantial influence on bond prices during and after bond issuance. Initially, firms with lower credit quality will have to pay higher interest rates to compensate investors for accepting higher default risk. After the bond is issued, a decrease in creditworthiness will also cause a decline in the bond price on the secondary market. Lower bond prices mean higher bond yields, which offset the increased default risk implied by lower credit quality.
As a practical matter, investors rely on bond ratings to measure credit quality. There are three primary rating agencies. The ratings that they assign act as signals to investors about the creditworthiness and safety of the bonds. Since bonds with poor ratings have a lower chance of repayment by the issuer, the prices of these bonds are also lower.
Pricing Callable Bonds
Investors should also be aware of the impact that a call feature has on bond prices. Callable bonds can be redeemed before the date of maturity at the issuer's discretion. Because of the possibility of early redemption, these bonds have a higher risk if interest rates have gone down. Declining interest rates make it more appealing to the issuer to redeem the bonds early. That means the investor will have to buy new bonds that pay lower interest rates.
If interest rates have gone up, a call feature will not greatly affect the bond's price. In such a situation, the issuer is less likely to exercise the option to call the bond.