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Understanding how bonds are priced

Understanding how bonds are priced

By Expert Panel 02.07.2018


Rising share prices and property values make for happy investors. An increase in interest rates results in higher term deposit rates and again, investors are pleased. An increase in bond yields however, and investors are not always content, sometimes confused, and often uncertain about the impact on their bond investments. So let’s look into interest rates and bond prices.

The price is right

There are two components to be aware of when you buy a bond – its price and its yield.

When you buy a bond, you are effectively making a loan to that government or corporation. In return for borrowing your capital, the bond is repaid in a specified time period. For the duration of the loan, you are rewarded with regular coupon (or interest) payments.

Coupons are set with regard to the prevailing interest rates at the time, and the yield is generally higher than the cash rate, to make the bond a more attractive investment than a term deposit.

If you buy a bond at issue and hold it through to maturity, the investment will not be affected by changes to interest rates. As illustrated in figure one, coupon payments remain the same for the duration of the investment, and at maturity, the principal investment is repaid.

Key point #1 – a bond bought at issue and held to maturity is not affected by changes to interest rates

Figure one: A bond bought at issue and held to maturity


Interest rates and bond prices

Key point #2 – a bond’s price moves in the opposite direction of its yield

A buy and hold strategy is straightforward. However, if you wish to buy (or sell) a bond on the secondary market (i.e. after it has been issued), the relationship between the bond’s price and its yield becomes important.

This relationship is sometimes depicted as a see-saw – as one rises, the other falls. As illustrated in figure two, the two factors have an inverse relationship; in other words, a bond’s price moves in the opposite direction of its yield.

Figure two: the effect of interest rates on bond yields and bond prices


The price of a bond reflects the value of the income it provides via regular coupon or interest payments. If interest rates fall, an older bond paying a higher rate becomes more valuable and will generally sell at a premium.

When interest rates rise, term deposits and newly issued bonds will pay investors higher rates than existing bonds – therefore the price of older bonds will generally fall to compensate and sell at a discount.

Key point #3 – when a bond sells at a discount, its price is lower than its issue price; when it sells at a premium, its price is above its issue price

How does this translate to XTBs?
 
As well as an original face value and coupon rate, each XTB has a current price, a current yield determined by its coupon rate and price, and a yield to maturity. We provide a table of available XTBs, which is updated daily using the previous market close data. This interactive table provides details of the available XTBs, and includes fixed and floating rate bonds across a range of sectors.

Figure three: Key measures of a corporate bond


Figure three details the facts you should review when considering an investment in an XTB; this example shows an XTB where interest rates have decreased (the current yield is lower than the coupon rate) and therefore, this XTB’s current price is higher than its face value:

The coupon rate of 7.75% would be paid to those investors who bought at issue (at $100) and held to maturity
An investor who bought at issue and sold this XTB today would profit from the price appreciation
An investor buying the XTB today would pay a higher price than its face value.
 
Key point #4 – the Yield to Maturity is the ‘total return’ you should receive if you buy the bond today and hold it to maturity

If you are considering XTBs for your portfolio, use the tools available to help you determine the most appropriate investment(s), given your income needs and likely investment timeframe.

Originally published by Richard Murphy, XTB


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