ADVANCED BOND PRICING

Basic 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 bondholders 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 issuer’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 issuer has a credit spread of 50 bps above the 10-year U.S. treasury yield. The bond yield for this corporate issuer is therefore, 2.066%. Determining the appropriate yield is essential for the issuer as it is the cost of the new issue and will set the price of the new issue.

Benchmark Rate

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 issuer’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.

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, corporate issuers need to maintain an up-to-date knowledge of these rates and the implications on their respective new issue coupon.

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 issuers 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. Issuers should plan their bond issues according to upcoming corporate events.


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

Determining the Credit Spread

Determining an appropriate credit spread is essential to the issuer’s go-to-market strategy. If the credit spread is too low, this could result in an under-subscription whereby the issuer fails to raise sufficient new issue proceeds. However, if the credit spread is too high, the issuer will incur a higher coupon rate on its bond. The issuer and dealers derive the credit spread by:

1. Secondary market analysis – the issuer can leverage the market information from the secondary market trading levels for their existing issues as a baseline for the credit spread of the new issue.


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


3. Comparable analysis – the issuer can reference the credit spreads of comparable issuers in their respective industry. 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 – the issuer and the dealers can directly contact investors for their sentiments on the new issue. Investors are the stakeholders who provide the capital to the issuer, so it is essential to engage them 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.