How do bonds get priced
Hi just tying to work out how bonds are priced ? thanks Andrew
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Answer
Sure, we’ll do our best Andrew!
When you buy a bond, you are effectively lending the bond issuer money from date of purchase to maturity. The issuer is generally a Government or a company offering their bonds for a specific time period. At maturity, the issuer pays back the amount they were lent. Bonds are generally priced at a flat $100 and have an attached coupon, which is the yield. Currently, the Australian Government is paying 4.4% per annum on a 10-year bond. That means, you receive $4.40 each year until the bond matures.
You will be paid more for risker bonds because the chance of a default is higher. This is known as a credit spread, which effectively prices the difference between safe government bonds and risker bonds.
The yield offered at the outset is based on current economic conditions, that can change. These changes will not impact your return if held to maturity, however, it can create some fluctuations during the holding period. If rates are cut, or the market expects they will be, new bonds can be issued paying a lower interest rate, making your 4.40% more valuable. If for example, interest rates are cut 0.5%, the government can now issue debt (bonds) paying 3.9%. Markets are broadly efficient, so the price of your bond will increase to reflect that change and vice versa if rates go up, you’re 4.40% could look relatively less attractive, and the price of your bond will decline.
The cost of capital is very important when pricing an asset. The higher the cost of capital, the lower the implied value and vice versa. If interest rates rise, asset values generally fall. There are some offsets here in so far as rates rise because economic growth could be stronger for instance, and assets could produce higher returns.
There are also floating rate bonds, where the yield will rise and fall inline with interest rates and the capital price will be less impacted by changes in rates.
As an example of a Corporate Bond, major Australian bank bonds with 5 years to run, are paying ~6% per annum.
We hope that helps.
