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In the world of finance, bonds play a crucial role. As proven by an impressive amount of $1.3 trillion, being the total market size of the government bonds and $0.6 trillion, being the total market size of the corporate bonds, as of September 2023.
Additionally, the total value of the bond securities has increased by more than 165% in the past 10 years, signalling a massive contribution to the country’s economy.
However, have you ever wondered, how these bonds are priced and why bond prices fluctuate? Even though they are fundamental to the financial sector, many still don’t understand how they are priced.
This article will unravel the mysteries of bonds and will provide the knowledge to navigate the bond market confidently.
What are bonds?
Investors lend money to borrowers through fixed-income instruments called bonds. Governments and corporations issue these as a means of raising capital. Buying a bond is like lending money to the issuer; they’ll pay you interest regularly and then repay you the face value of the bond when it matures.
Bonds come in many forms, each designed to meet the needs of investors with varying risk tolerances and long-term objectives. It is common practice to view bonds issued by national governments as investments with a high degree of safety. Companies, on the other hand, offer more risky but potentially lucrative corporate bonds.
Factors influencing bond pricing
Many factors influence the bond’s market value significantly, which in turn affects bond prices.
- Interest rates
- Time to maturity
- Creditworthiness
You can learn a lot about the dynamics of bond prices and make smart choices if you keep these things in mind.
Yield, in its most basic definition, is the rate of return on an investment, including interest earned on a security’s holdings. An investment’s yield is typically stated as a percentage based on its face value, market value, or cost.
Bond yields and bond prices are inversely correlated; as bond prices go up, yields go down and vice versa.
The reason behind this inverse relationship is that bond prices and demand go down when market interest rates go up because fixed interest payments on bonds become less appealing compared to other investments.
The relationship between bond prices and yields
On the flip side, when market interest rates drop, bond prices go up because investors like the security of fixed-interest payments.
Yield Curve
Interest rates on debt across different maturities are shown graphically by the yield curve. It reveals the rate of return that a lender can anticipate for a specific time frame. Interest rate and economic activity movements in the future can be inferred from the yield curve’s slope.
How is the bond price calculated?
You might be curious about how bonds are priced. It entails figuring out how much its cash flows in the future are worth right now. Upon maturity, the cash flows from the bond will consist of its face value plus the periodic coupon payments.
To calculate the bond price, this equation is used:
Bond price = C((1-(1(1+r)n))r) + FV(1+r)n
Where,
C is the periodic coupon payment
r is the yield-to-maturity rate
n is the number of periods
FV is the face value of the bond
Let’s see an example to better understand how to calculate bond prices.
Imagine for a moment that our bond possesses the following properties:
Coupon payment (C): ₹50 per year
Yield to Call (r): 5% per year
Number of periods (n): 5 years
Face Value (FV): ₹1000
We can substitute these values into the bond price formula:
Bond price = 50((1-1(1+0.05)5)0.05) + 1000(1+0.05)5 =₹1000
By calculating the above expression, we can find the price of the bond. All of the cash flows (coupon payments and face value) that are anticipated to be generated by the bond in the future, discounted at the yield-to-maturity rate, are represented by this price.
Full and Flat price
Moreover, in the bond market, you’ll often hear the terms “full price” and “flat price”.
To give you a clearer picture, let’s suppose the bond has a coupon payment due in a few days. Even though the bond was held for the majority of the coupon period by the previous owner, if you were to purchase the bond today, you would still receive that coupon payment.
It is a common practice to adjust the bond’s trading price by adding the amount of the upcoming coupon payment to reflect this. The term “dirty price” or “full price” refers to the outcome.
But then, how to calculate the flat price of a bond? The “flat price” is the full price minus this upcoming coupon payment.
Bottomline
One of the most essential things for bond investors to know is how bonds are priced. Interest rates, the length of time until maturity, and credit quality are just a few of the variables that can affect this intricate process. Important factors in bond pricing include the flat price idea, the inverse relationship between bond prices and yields, and pricing models.
The greater your familiarity with these concepts, the more competent you will be to handle the complexities of the financial markets and make wise investment decisions.
FAQs
Bonds are often priced at 100, which is called par value. This is the face value of the bond or the amount that will be returned to the bondholder at maturity. The price of a bond in the market will fluctuate based on interest rates, time to maturity, and credit risk.
In India, bonds are sold by various entities. These include nationalised banks, scheduled private banks, scheduled foreign banks, designated post offices, and the Stock Holding Corporation of India Ltd. (SHCIL). Additionally, authorised stock exchanges also sell bonds either directly or through their agents.
Bond prices fall when market interest rates rise. This is because new bonds issued offer higher coupon payments, making existing bonds less attractive. To compensate, the price of existing bonds decreases until their yield matches the new higher interest rate, hence the fall in bond prices.
Yes, individuals in India can buy bonds directly. This can be done through a demat and trading account with a brokerage house. The RBI Retail Direct Scheme also allows individuals to buy treasury bills, dated securities, and state development loans directly from the primary and secondary markets.
Whether RBI bonds are better than Fixed Deposits (FDs) depends on your investment goals. RBI bonds can offer higher returns and are considered safer as they are backed by the government. However, FDs offer guaranteed returns and are less volatile. It’s important to consider these factors before investing.
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