Finance
Bond Pricing
Bonds priced inverse to interest rates — fundamental fixed-income concept
Bonds are debt securities — borrower (issuer) pays bondholder fixed interest (coupons) and principal at maturity. Bond price: present value of future cash flows. Inverse relationship to interest rates: when rates rise, existing bond prices fall (and vice versa). Yield: return if held to maturity. Yield curve: rates at different maturities. Types: government, corporate, municipal. Risk factors: interest rate risk, credit risk, liquidity, inflation. Foundation of: fixed income investing, central bank operations (open market operations affect bond prices). Major asset class: globally ~$120 trillion bond market vs ~$100 trillion stock market.
- DefinitionDebt security; pays interest + principal
- Price-rate inverseRates up → prices down (and vice versa)
- Yield to maturityTotal return if held to maturity
- Coupon rateFixed interest rate
- Major typesGovernment, corporate, municipal
- RisksInterest rate, credit, liquidity, inflation
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Why bond pricing matters
- Investment. Major asset class.
- Retirement portfolios. Income, stability.
- Government finance. Treasury bond market.
- Corporate finance. Cost of debt.
- Monetary policy. Central banks affect prices.
- Risk management. Hedging, duration matching.
- Education. Foundation of finance.
Common misconceptions
- Bonds always safe. Interest rate, credit, inflation risks.
- Coupon rate = yield. Different (yield reflects current price).
- Higher yield always better. Reflects risk.
- Bonds boring. Larger market than stocks; complex.
- Same as savings account. Different — fluctuating value.
- Government bonds zero risk. Inflation, sovereign risk possible.
Frequently asked questions
What's a bond?
Debt security. Issuer (government, company, municipality) borrows money. Pays bondholder. (1) Periodic coupon (interest, often semi-annual). (2) Principal (face value) at maturity. Common: $1000 face value. Different from stocks (ownership). Bondholders: creditors with priority over stockholders in bankruptcy.
How are bonds priced?
Present value of future cash flows. Bond price = sum of coupons discounted by yield + principal discounted. Formula. P = C × [1 - (1+y)^-n] / y + F / (1+y)^n. Where C = coupon, F = face, n = periods, y = yield. When yields = coupon rate: bond at par (face value). Higher yields: bond below par. Lower: above par.
Why inverse to rates?
Existing bonds compete with new bonds. Suppose bond pays 5% coupon. Rates rise to 7%. Why buy 5% bond? Only if priced below face value. Existing bond price falls. Inverse relationship. Mathematically: PV decreases when discount rate rises. Magnitude depends on duration.
What's yield to maturity?
Total return if bond held to maturity. Single discount rate equating bond price to present value of cash flows. Includes coupons and capital gain/loss. Used to compare bonds. Different from current yield (just coupon/price). YTM: more comprehensive measure. If price = face value: YTM = coupon rate.
What's a yield curve?
Plot of yields vs maturity. Normal: upward-sloping (longer = higher yield). Inverted: short > long (recession indicator). Flat: similar across maturities. Shape matters. (1) Steepening: economic expansion expected. (2) Flattening: slowing. (3) Inverting: potential recession. Watched closely as economic indicator.
What's bond duration?
Measure of price sensitivity to interest rate changes. Modified duration: % price change per 1% rate change. Higher: more sensitive. Long-term, low-coupon bonds: higher duration. Short-term, high-coupon: lower. Practical: matches asset duration to liability duration (insurance, pension funds). Bond risk management.
What's credit risk?
Risk of default. Issuer can't pay. Government bonds (US, etc.): low credit risk. Corporate: varies. Investment grade (AAA-BBB): low risk. High-yield (junk, BB and below): higher. Credit spread: yield over Treasuries. Rating agencies (Moody's, S&P, Fitch): assess. 2008 crisis: rating agency credibility damaged. Default rates vary by rating.