Generally when we talk about bond pricing we also include other fixed income investments. Thus this section would be more aptly named Stock and Fixed income valuation. But for tradition we won't complain ;-)
Bond pricing is fairly easy. From the provisions in the bond contract (or bond covenant as it is often called) we have a decent idea of what the cash flows will be and when they will occur. Of course there is the risk of default which is why information asymmetries are more important for lower rated bonds.
Assuming no default for a moment, bond pricing is almost entirely a
function of interest rates.
For a straight coupon bond, break the cash flows into an annuity and
a lump sum. These can be priced separately and then added back
together to calculate the total bond value.
Example:Note that it is not coincidence that this bond is selling at a discount (that is below par). Companies usually try to sell new bonds at par, so if companies are selling new bonds with 7% interest, you would rather buy that than a similarly priced bond with 6% interest. So to persuade you to buy the lower coupon bond, the price is reduced.
Suppose a 5 year bond pays an 6% annual coupon. This 6% refers to the interest payments and is calculated as a percentage of par. Unless otherwise stated, assume the principle value is $1000. Thus each year you would receive 6% of $1000 which is $60. In addition in the last year you would receive the original $1000 back. Further assume that the going rate of interest for such a bond is 7%. You must find the price of the bondThe timeline of this would be :
______________________________
60 60 60 60 60
1000The PV of the annuity is
$60(PVIFA(7%,5)) = $60*4.1002 = $246.01
The PV of the principle amount is
$1000/(1.07)5= 712.99By adding the two together you get $959
The Wall Street Journal (WSJ) reports bond prices as a % of par. Hence 102=102% of par which would be $1020. The bond in the above example would be quoted as 95.9. You should know how to read bond prices.
Types of Bonds
There are many different types of bonds. This is to meet the
needs of both investors and issuers. Some of the different types
are:
- Treasury Bonds
- US Agency Bonds
- Corporate Bonds
- Callable bonds
- Convertible bonds
- Puttable bonds
- Floating
- Fixed
- Extendables
- Sr. Debt
- Jr. Debt
- Mortgage backed
- Debentures
- Income Bond
- Eurobond
- Zero Coupon
- Original Issue Discount Bonds
- etc.
In addition to all of these types of debt instruments, Preferred
Stock is usually included as a fixed income security. The difference
between debt and preferred stock is that failure to pay the dividend does
not result in bankruptcy. It should be noted that often in preferred
stock the firm must pay any dividends that are arrears before any common
dividend can be paid. Preferred Stock trades very much like debt
instruments. There is much less of an informational asymmetry and
price changes with interest rate changes.
It should also be noted that many types of engineered securities trade exactly like bonds. For example many investment banking firms sell Strips. These are similar to zero coupon bonds. The Investment bankers merely strip the coupons off of Treasury bonds and sell the two series of cash flows: the coupon payments and the principle amounts.
Many other type of securities are in many ways similar to bonds.
For example swaps, IOs, and POs. These are slightly more complex,
but once you have your timeline drawn, they are priced very much like anything
else.
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