What determines the price of a bond?

Apr 29

What determines the price of a bond?


When bonds are traded in the secondary market, the price of the bond is influenced by the demand and supply of the bond. The other factors that affect the price are:

Interest rates

Bond price and interest rate share an inverse relationship. Interest rate in this case means the benchmark interest rate. Taking the same example we considered earlier and the rate on short-term treasury security as the benchmark interest rate is how the relation can be explained.

If the treasury rate is the same 5 percent, both the treasury and company XYZ’s bond will offer the same return of $500 per year. Let us assume, due to deteriorating fundamentals, the interest rate on the treasury falls to 3 percent, so it fetches you $300 compared to the $500 XYZ’s bond yields. The higher yield of XYZ’s bond makes it an attractive option, sending its price higher. The price of the bond rises until its return becomes equal to the reduced returns from the treasury.

Conversely, when the treasury rate rises to 7 percent, it would fetch you $700. Given the lower returns from company XYZ’s bond, demand for it dwindles, sending its price lower. The price of the corporate bond drops till its yield becomes equal to the enhanced yield of the treasury.

Inflation

Bond prices also share an inverse relationship with inflation. In an inflationary environment, the future returns you earn from a bond will be worth less in today’s dollar. This is because inflation erodes the purchasing power of the returns you will earn on your investment.

Credit rating of the bond

The credit rating assigned to a bond by a rating agency indicates the ability of a bond issuer to pay the periodic interest payments and repay the principal amount at the time of maturity. A higher credit rating will lead to a higher bond price.