Question

Question 6: Bond Pricing, Yield to Maturity and Related Issues a. Illustrate the approach of bond pricing b. Comment on relationship of bond price and yield to maturity c. Factors that may affect government bond prices

Answer 1

Ans a)

Assuming you know Bond Basics, there are 5 factors that go into influencing a bond’s price fundamentally. They are:

• Par Value or Face Value and Principal (FV):The amount of money lent to the issuer of the bond (borrower). Par Values are generally in 100 or 1000 per bond. The principal is the number of bonds bought multiplied by the par value.
• Tenor or years to maturity (n): The number of time periods it takes for the bond to mature or get redeemed where the issuer pays back the principal or par value (in the case of a single bond).
• Yield to Maturity (YTM): The rate of return on the bond if held till maturity.
• Coupon Rate: This is the interest rate paid by the issuer for the amount borrowed. The fixed returns/cash flows or coupon flows that the issuer pays as interest payments is calculated by multiplying the Coupon Rate with the Par Value (C) for a single bond.
• Time Value of Money (Discount factor): A basic concept in finance where a dollar today is worth more than a dollar tomorrow since interest rates feature into the bond pricing calculation. So, if $1 today equals $1 x (1+5%)^2 = $1.1025 after two years assuming interest compounds, then $1.1025 after two years is basically $1 today discounting it at a 5% interest rate.

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Ans b) There is an inverse relationship between market price of the bond and its yield. The higher the market price, the lower the return and the lower the market price the higher the return in bond.

The main reason that affect bond price is market rating of the issuing company, interest rate and inflationary expectations. People prefer bond holding to shares to protect their capital in times of inflation.

In case of share holding the return may be high but sometimes the value of share holding may crash wiping out the entire capital.

Bond prices manage interest rate risk to protect the capital of the investor in a better manner.

Ans c) 1)stocks versus Bonds

When stocks are on the rise, investors generally move out of bonds and flock to the booming stock market. When the stock market corrects, as it inevitably does, or when severe economic problems ensue, investors seek the safety of bonds. As with any free-market economy, bond prices are affected by supply and demand.

2)understanding Yield

The yield is the discount rate of the cash flows. Therefore, a bond's price reflects the value of the yield left within the bond. The higher the coupon total remaining, the higher the price. A bond with a yield of 2% likely has a lower price than a bond yielding 5%. The term of the bond further influences these effects.

3)changes in interest rate, inflation and Credit Ratings

Changes in interest rates affect bond prices by influencing the discount rate. Inflation produces higher interest rates, which in turn requires a higher discount rate, thereby decreasing a bond's price. Bonds with a longer maturity see a more drastic lowering in price in this event because, additionally, these bonds face inflation and interest rate risks over a longer period of time, increasing the discount rate needed to value the future cash flows. Meanwhile, falling interest rates cause bond yields to also fall, thereby increasing a bond's price.

Credit risk also contributes to a bond's price. Bonds are rated by independent credit ratingagencies such as Moody's, Standard & Poor's and Fitch to rank a bond's risk for default. Bonds with higher risk and lower credit ratings are considered speculative and come with higher yields and lower prices. If a credit rating agency lowers a particular bond's rating to reflect more risk, the bond's yield must increase and its price should drop.