7.1 Introduction

Introduction

Understanding the potential risks and rewards of fixed-income securities, such as bonds, is crucial before recommending them to clients. This includes comprehending how bond yields and prices are determined and recognizing the strong relationship between prices and prevailing interest rates.

In the most common scenario, an investor buys a bond at one price, receives regular interest payments, holds the bond to maturity, and redeems it at face value. However, fixed-income securities can also be purchased in the secondary markets. The price that an investor pays for a security in the secondary market is equally applicable to bonds as it is to equities. Pricing is especially important for investors aiming for capital gains in the bond market. Both bond prices and equity prices are influenced by economic conditions and changes in interest rates, though they do not react in the same manner.

In this chapter, we focus on the methods used to determine the fair price for a fixed-income security and pricing properties. You will also learn about the impacts that various events have on the markets and on the prices of fixed-income securities.

Key Concepts

Bond Yields and Prices

Bond yields represent the return an investor can expect to earn from holding a bond. Understanding yields is fundamental to appreciating the price-earnings relationship in fixed-income securities. The yield of a bond can be categorized into several types:

• Coupon Yield: The fixed interest rate paid by the bond issuer relative to its face value.

• Current Yield: The annual interest payment divided by the bond’s current market price:

  $$ ext{Current Yield} = \frac{ ext{Annual Interest Payment} }{ ext{Current Market Price} } $$

• Yield to Maturity (YTM): The total return an investor can expect to earn by holding the bond until it matures. YTM considers the bond’s current market price, face value, coupon interest rate, and time to maturity.

Relationship Between Bond Prices and Interest Rates

Bond prices and interest rates have an inverse relationship. When interest rates rise, the prices of existing bonds fall, and vice versa. This occurs because new bonds are issued at the new higher rates, making existing bonds with lower rates less attractive, thus lowering their prices.

Key factors influencing bond prices include:

• Interest Rate Risk: Risk of changing interest rates affecting bond prices.
• Credit Risk: The risk of bond issuer defaults impacting price.
• Inflation Risk: The eroding effect of inflation on returns.

Secondary Market and Prices

Investors can buy and sell bonds in the secondary market. The prices in secondary markets are influenced by various factors including the bond’s credit quality, economic conditions, market demand, and changes in interest rates.

Capital Gains in Bond Market

For investors seeking capital gains, predicting future interest rates and understanding economic conditions is crucial. Timing the purchase and sale of bonds can achieve significant returns due to the price volatility associated with interest rate movements.

Core Methods in Pricing Fixed-Income Securities

1. Present Value Calculation: Current value of the bond’s future cash flows must be calculated to determine the fair price.
2. Discounting Cash Flows: Future cash flows are discounted back to their respective present values using an appropriate discount rate (usually the prevailing interest rate).

Formula for Present Value of a Bond

The present value (PV) of a bond is calculated by summing the present value of its interest payments and the present value of the face value at maturity:

where:

• \(PV\) = Present value of the bond
• \(C\) = Coupon payment
• \(F\) = Face value of the bond
• \(r\) = Discount rate (Interest rate)
• \(T\) = Number of periods to maturity

Frequently Asked Questions

What is a bond yield?

A bond yield is the return an investor realizes on a bond. This can include different types of yields, such as coupon yield, current yield, and yield to maturity (YTM).

How do interest rates affect bond prices?

Bond prices and interest rates have an inverse relationship: when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This happens because new bonds issued at higher rates make existing bonds with lower rates less attractive.

What factors influence bond prices?

Several factors influence bond prices, including interest rate risk, credit risk, inflation risk, and overall economic conditions.

What is the secondary market for bonds?

The secondary market is where investors buy and sell bonds from other investors rather than from the issuing entity. Prices in this market are influenced by various factors, including market demand and changes in interest rates.

Key Takeaways

• Understanding bond yields and the intricate relationship between bond prices and interest rates is fundamental for recommending fixed-income securities.
• The secondary market allows for trading bonds at market-determined prices, providing both opportunities and risks for investors aiming for capital gains.
• Pricing fixed-income securities involves calculating the present value of future cash flows using appropriate discount rates.

Glossary

• Bond Yield: The return an investor earns on a bond.
• Secondary Market: Market where securities are traded after initial issuance.
• Interest Rate Risk: The potential change in bond prices due to fluctuations in interest rates.
• Discount Rate: The interest rate used to discount future cash flows to their present values.
• Present Value: The current worth of a future sum of money or stream of cash flows given a specified rate of return.