Bond Pricing and Valuation

Let’s say you buy a ₹1,000 bond for ₹980 today. You’re essentially paying less than its face value, with the promise of receiving ₹1,000 at maturity. How do you determine if this is a good deal? Understanding bond pricing and valuation helps investors decide whether bonds are fairly priced in the market or not.

What Determines Bond Prices?

Bond prices fluctuate based on several factors, primarily interest rates, credit quality of the issuer, and time to maturity. When interest rates rise, existing bond prices fall to match the higher yields offered by new bonds, and vice versa.

Key Concepts in Bond Pricing:

1. Face Value (Par Value):
   The amount paid back to the bondholder at maturity.
   

2. Coupon Rate:
   Fixed interest paid periodically to the bondholder.
   

3. Yield to Maturity (YTM):
   The total expected return if the bond is held until maturity, considering current price, coupon payments, and principal repayment.
   

4. Current Price:
   The price at which the bond is trading in the market.
   

How to Calculate Bond Price:

The price of a bond is the sum of the present value of its future coupon payments and the present value of its face value at maturity. This is expressed as:

P= t=1 ∑ n (1+r) t C + (1+r) n F

Where:

• P = price of the bond
  
• C = coupon payment
  
• F = face value
  
• r = yield to maturity (discount rate)
  
• n = number of periods to maturity
  

Example: Consider a ₹1,000 bond with a 6% annual coupon and 3 years to maturity. If the market yield (YTM) is 5%, the price is calculated by discounting the coupon payments and the principal back to present value at 5%.

Why Does Bond Price Fluctuate?

• Interest Rate Changes: When market interest rates rise above a bond’s coupon rate, its price falls to make its yield competitive.
  

• Credit Rating Changes: If the issuer’s credit rating deteriorates, the bond price will fall as investors demand higher yields for increased risk.
  

• Time to Maturity: As maturity approaches, bond prices tend to move toward face value.
  

In India, government securities and corporate bonds are actively traded on exchanges like the NSE and BSE. Prices and yields fluctuate based on RBI policy changes, inflation expectations, and credit events in the market.

Understanding bond pricing is crucial for investors to assess whether a bond is trading at a discount, premium, or par, helping them make informed investment choices. In the next chapter, we will explore the Correlation of Interest Rates and Bond Values, diving deeper into the dynamics that affect bond prices.