ADVANCED BOND PRICING

Price Discovery

In the primary bond market, investors play a key role in the price discovery process of a new issue. On the launch date, the bookrunners work with investors and the issuer to set the principal amount and credit spread or coupon rate for the bond. A key determinant of bond price is investor demand for the new issue.

Bond Price

The bond price can be calculated by summing up future cash flows discounted to the present value. This method is used to price both new issues (primary bond market) and existing issues (secondary market). Read more about calculating the bond price here.

Coupon Rate

The coupon rate is the percentage of par value that will be paid to investors on a fixed schedule. It represents a stable source of income that bondholders will receive throughout the lifetime of the bond. Factors affecting the coupon rate include:

1. Prevailing market interest rates – the coupon rate is influenced, in particular, by prevailing market interest rates (e.g. U.S. treasury bonds) of similar structure and credit quality. For instance, investors will demand a higher coupon rate for a corporate bond rated BBB relative to a U.S. treasury bond of similar structure.


2. Tenor – the length of the bond’s maturity from the present (the tenor) influences the bond’s coupon rate. Generally, bonds with longer tenors have higher coupon rates than similar bonds with shorter tenors.

Components of Yield

Bond yield is the discount rate used to convert future cash flows to present values to derive the price of a bond. The yield is comprised of the bond’s market issuance premium – the “credit spread” – and the benchmark rate (e.g. U.S. treasury yield). Bond yield has an inverse relationship with bond price. As yield increases, the bond price decreases. Conversely, if bond yield decreases, bond price will increase.

Sample Corporate Bond Yield

This corporate bond has a credit spread of 50 bps above the 10-year U.S. treasury yield. The bond yield for this bond is therefore, 2.066%. Deriving the appropriate yield is essential for the investor as it determines the price of the investment, helping them make informed investment decisions that are appropriate for their investment style.

Benchmark Rate

The benchmark rate represents a similarly termed rate for a federal government bond. These benchmark bonds typically have low risk of defaulting (e.g. U.S. treasury, government of Canada). Major factors affecting the benchmark rate include:

1. Policy – changes to government monetary and fiscal policies will cause government benchmark yield to fluctuate.


2. Supply and demand – the laws of supply and demand will push the government benchmark yield to a market equilibrium.


3. Inflation outlook – inflation outlook reflects the buying power of the economy. As a result, higher inflation will drive the government benchmark yield up because investors will require higher cash flow to compensate for the decrease in buying power.

The benchmark rate reflects the relative health of the economy and is largely influenced by macroeconomic factors. Despite having little influence on the benchmark rates, investors need to maintain an up-to-date knowledge of these rates and the implications on their respective portfolios.

Credit Spread

The credit spread is the portion of the bond yield that an investor would require to invest in a non-government benchmark bond offering. It is measured in bps (0.01%). Credit spread is determined by the issuer’s credit strength, comparable bonds in the market, and investor sentiment. Major factors affecting the credit spread include:

1. Market conditions – investors will require higher returns to compensate the increased risk of investing in poor market conditions, resulting in a widened credit spread.


2. Other asset classes – the performance of other asset classes directly contribute to the market for fixed income securities. The credit spread will tighten if investor demand increases for fixed income securities as a result of poor performance in other asset classes.


3. Financial health – declining financial health will make an issuer’s bonds riskier (default and credit risk), causing the credit spread to widen to reflect this increased risk. One key measure used to ascertain liquidity and default risk is the issuer’s credit rating.


4. Company outlook – corporate events (e.g. mergers, bankruptcy, earnings call) can reveal new information in the market that will be reflected in the credit spread. A negative corporate event will cause the credit spread to widen.


5. Comparable issuers – corporate bond credit spreads are influenced by comparable bonds. Generally, the bond’s credit spread is directly correlated to comparable bonds in the same sector.

Determining the Credit Spread

Determining an appropriate credit spread is essential to the investor’s investment analysis. If the credit spread is too low, the investor will receive unattractive yield. Conversely, if the credit spread is too high, the investor should be considerate of the credit risk of the issuer. The credit spread for a new issue is derived by:

1. Secondary market analysis – market information from the secondary market trading levels for existing bonds as a baseline for the credit spread of the new issue.


2. Recent transaction analysis – similarly-structured recent issues from the issuer or other comparable issuers imply the market demand for a prospective new issue.


3. Comparable analysis – the credit spreads of comparable issuers in the issuer industry can be referenced for the price discovery process. This analysis reflects the perceived risk in the issuer’s industry by investors, a strong starting point for determining their credit spread.


4. Investor sentiment – investors are the stakeholders who provide the capital to the issuer, so they are essential in the pricing process. Ultimately, investors provide the feedback necessary to determine the credit spread of the issuer through the marketing and price discovery processes.

The Market

The fixed income market is an over-the-counter (OTC), bilateral market in which trades occur between counterparties at negotiated prices. As a result, multiple transactions of the same bond may yield greatly varying prices. In contrast to the exchange-traded equity market, investors in the fixed income market may experience pricing and liquidity challenges.