Bond prices are determined by 5 factors:
- par value
- coupon rate
- prevailing interest rates
- accrued interest
- credit rating of the issuer.
Generally, the issuer sets the price and the yield of the bond so that it will sell enough bonds to supply the amount that it desires. The higher the credit rating of the issuer, the lower the yield that it must offer to sell its bonds. A change in the credit rating of the issuer will affect the price of its bonds in the secondary market: a higher credit rating will increase the price, while a lower rating will decrease the price. The other factors that determine the price of a bond have a more complex interaction.
When a bond is first issued, it is generally sold at par, which is the face value of the bond. Most corporate bonds, for instance, have a face and par value of $1,000. The par value is the principal, which is received at the end of the bond’s term, i.e., at maturity. Sometimes when the demand is higher or lower than an issuer expected, the bonds might sell higher or lower than par. In the secondary market, bond prices are almost always different from par, because interest rates change continuously. When a bond trades for more than par, then it is selling at a premium, which will pay a lower yield than its stated coupon rate, and when it is selling for less, it is selling at a discount, paying a higher yield than its coupon rate. When interest rates rise, bond prices decline, and vice versa.
Bond Value Equals the Sum of the Present Value of Future Payments
A bond pays interest either periodically or, in the case of zero coupon bonds, at maturity. Therefore, the value of the bond is equal to the sum of the present value of all future payments. The present value is calculated using the prevailing market interest rate for the term and risk profile of the bond, which may be more or less than the coupon rate. For a coupon bond that pays interest periodically, its value can be calculated thus:
Bond Value = Present Value (PV) of Interest Payments + Present Value of Principal Payment
Bond Value = PV(1st Payment) + PV(2nd Payment) + ... + PV(Last Payment) + PV(Principal Payment)
C = coupon, or interest, payment per period
P = par value of bond
n = number of years until maturity
r = market interest rate
Example — Calculating Bond Value as the Present Value of its Payments
Suppose a company issues a 3-year bond with a par value of $1,000 that pays 4% interest annually, which is also the prevailing market interest rate. What is the present value of the payments?
The following table shows the amount received each year and the present value of that amount. As you can see, the sum of the present value of each payment equals the par value of the bond.
|Year||Payment||Amount Received||Present Value|
|3||Interest + Principal||$1040||$924.56|
In the primary bond market, where the buyer buys the bond from the issuer, the bond usually sells for par value, which is equal to the bond's value using the coupon rate of the bond. However, in the secondary bond market, bond price still depends on the bond's value, but the interest rate to calculate that value is determined by the market interest rate, which is reflected in the actual bids and offers for bonds. Additionally, the buyer of the bond will have to pay any accrued interest on top of the bond's price unless the bond is purchased on the day it pays interest.
Bond Price Listings
When bond prices are listed, the convention is to list them as a percentage of par value, regardless of what the face value of the bond is, with 100 being equal to par value. Thus, a bond with a face value of $1,000 which is selling for par, sells for $1,000, and a bond with a face value of $5,000 that is also selling for par will both have their price listed as 100, which means their prices are equal to 100% of par value, or $100 for each $100 of face value.
This pricing convention allows different bonds with different face values to be compared directly. For instance, if a $1,000 corporate bond was listed as 90 and a $5,000 municipal bond was listed as 95, then it can be easily seen that the $1,000 bond is selling at a bigger discount, and, therefore, has a higher yield. To find the actual price of the bond, the listed price must be multiplied as a percentage by the face value of the bond, so the price for the $1,000 bond is 90% × $1,000 = 0.9 × $1,000 = $900, and the price for the $5,000 bond is 95% × $5,000 = .95 × $5,000 = $4,750.
A point is equal to 1% of the bond’s face value. Thus, a point's actual value depends on the face value of the bond. Thus, 1 point = $10 for a $1,000 bond, but $50 for a $5,000 bond. So a $1,000 bond that is selling for 97 is selling at a 3 point discount, or $30 below par value, which equals $970.
No commission is charged when buying or selling bonds. A bond dealer makes money through the spread—the difference between the bid price, which is what the dealer is willing to pay for a bond, and the ask price, which is what the dealer is selling the bond for. To keep the spread further apart, bond prices are generally listed in 1/32 increments of a point, or a higher multiple, although some Treasuries have price differentials as low as 1/64. (Another reason for this convention is that a point is not equal to a dollar, but a decimal base would still be more convenient.) The pricing convention is to list the point after a dash. Thus, a price listed as 102-04 is equal to 102 + 4/32 = 102 + 1/8 = 102.125% of par value. If this listed price were for a $1,000 face-value bond, then this price would be equal to $1,021.25 (= $1,000 × 102.125% = $1,000 × 1.02125). The integer point value, in this case 102, is known as the handle. When traders negotiate, the handle is usually known and not expressed. So a trader might say that he’ll offer 2 for the bond, meaning the handle + 1/16 (= 2/32).
Because the trading volume in Treasuries is much greater than for other bonds, Treasuries sometimes trade in 1/64 increments. A 1/64 increment is denoted by a plus next to the listed price. So a U.S. Treasury bond with a $1,000 face value that is listed as 101-1+ = 101 + 1/32 + 1/64 = 101 + 3/64 = 101.046875, so the bond’s price = 101.046875% × 10 = $1010.47 (rounded). Thus, 1,000 of these bonds would cost $1,010,468.75.
Listed bond prices are flat prices (aka clean prices), which do not include accrued interest. Most bonds pay interest semi-annually. For settlement dates when interest is paid, the bond price is equal to the flat price. Between payment dates, accrued interest must be added to the flat price, which is often called the dirty price:
Dirty Bond Price = Flat Price + Accrued Interest
Accrued interest is the interest that has been earned, but not paid, and is calculated by the following formula:
|Accrued Interest = Interest Payment ×||Number of Days since Last Payment|
Number of Days between Payments
When you actually buy a bond on the secondary market, you would have to pay the former owner of the bond the accrued interest. If this were not so, you could make a fortune buying bonds right before they paid interest then selling them afterward. Because the interest accrues every day, the bond price increases accordingly until the interest payment date, when it drops to its flat price, then starts accruing interest again.
Example — Calculating the Purchase Price for a Bond with Accrued Interest
You purchase a corporate bond with a settlement date on September 15 with a face value of $1,000 and a nominal yield of 8%, that has a listed price of 100-08, and that pays interest semi-annually on February 15 and August 15. How much must you pay?
The semi-annual interest payment is $40 and there were 31 days since the last interest payment on August 15. If the settlement date fell on a interest payment date, the bond price would equal the listed price: 100.25% × $1,000.00 = $1,002.50 (8/32 = 1/4 = .25, so 100-08 = 100.25% of par value). Since the settlement date was 31 days after the last payment date, accrued interest must be added. Using the above formula, with 184 days between coupon payments, we find that:
|Accrued Interest = $40 ×||31|
Therefore, the actual purchase price for the bond will be $1,002.50 + $6.74 = $1,009.24.
Tip: In most cases, it will be more convenient to use a spreadsheet, such as Excel, that provides several functions for determining the number of days or the dirty bond price, with the settlement and maturity dates expressed as either a quote (e.g., "12/11/2012") or as a cell reference (e.g., B12):
|Number of Days since Last Payment =||COUPDAYBS(settlement,maturity,frequency,basis)|
|Number of Days Between Payments =||COUPDAYS(settlement,maturity,frequency,basis)|
|Bond Price =||PRICE(settlement,maturity,rate,ytm,redemption,frequency,basis)|
Search Help for more information. Below is another example of obtaining a bond's price by using Excel's PRICE function:
|6.50%||Yield to Maturity|
|2||Number of Interest Payments per Year|
|1||Day Count Basis (Month/Year = Actual/Actual)|
|94.63544921||% of Par Value of Actual Price for Corporate Bond, $1,000 Face Value|
|$946.35||Actual Price for Corporate Bond, $1,000 Face Value|
To calculate the accrued interest on a zero coupon bond, which pays no interest, but is issued at a deep discount, the amount of interest that accrues every day is calculated by using a straight-line amortization, which is found by subtracting the discounted issue price from its face value, and dividing by the number of days in the term of the bond. This is the interest earned in 1 day, which is then multiplied by the number of days from the issue date.
Steps to Calculate the Price of a Zero Coupon Bond
- Total Interest Paid by Zero Coupon Bond = Face Value - Discounted Issue Price
- 1 Day Interest = Total Interest / Number of Days in Bond's Term
- Accrued Interest = (Settlement Date - Issue Date) in Days × 1 Day Interest
- Zero Coupon Bond Price = Discounted Issue Price + Accrued Interest
PRICE, PRICEDISC, PRICEMAT, and DISC Functions in Microsoft Office Excel for Calculating Bond Prices and Other Securities Paying Interest
Microsoft Excel has several formulas for calculating bond prices and other securities paying interest, such as Treasuries or certificates of deposit (CDs), that include accrued interest, if any.
Examples—Using Microsoft Office Excel for Calculating Bond Prices and Discounts
The following listed variables — where they apply — will be used for each of the example calculations that follow, for a 10-year bond originally issued in 1/1/2008 with a par value of $1,000:
- Settlement date = 3/31/2008
- Maturity date = 12/31/2017
- Issue date = 1/1/2008
- Coupon rate = 6%
- Yield to maturity = 8%
- Price (per $100 of face value) = 21.99
- Redemption = 100
- Frequency = 2 for most coupon bonds.
- Basis = 1 (actual/actual)
Price of a bond with a yield to maturity of 8%:
Bond Price =PRICE("3/31/2008","12/31/2017",0.06,0.08,100,2,1) = 86.62092 = $866.21
The discount price of a zero coupon bond with a $1,000 par value yielding 8%:
Price Discount =PRICEDISC("3/31/2008","12/31/2017",0.06,0.08,100,1) = 21.99288 = $219.93
The interest rate of a discounted zero coupon bond paying $1,000 at maturity, but that is now selling for $219.90:
Interest Rate of Bond Discount = DISC("3/31/2008","12/31/2017",21.99,100,1) = 0.080003 = 8%
- Note that the PRICEDISC function value has been rounded, with the results used in the DISC function to verify the results. (21.99 = $219.90 for a bond with a $1,000 par value).
PRICEMAT calculates the prices of securities that only pay interest at maturity:
What is the price of a negotiable, 90-day CD originally issued for $100,000 on 3/1/2008 with a nominal yield of 8%, a current yield of 6% and a settlement date of 4/1/2008? Using the Microsoft Excel Date function, with format DATE(year,month,day), to calculate the maturity date by adding 90 days to the issue date, and choosing the banker's year of 360 days by omitting its value from the formula, yields the following results:
Market Price of CD = PRICEMAT("4/1/2008",DATE(2008,3,1)+90,"3/1/2008",0.08,0.06) = 100.3181 (per $100 of face value) × 1,000 = $100,318.10