A bond’s market price, like the price of any financial asset, represents the present value of the stream of future cash flows to the bondholder.
A dollar in your hand today is worth more than a dollar that you receive a year from now due to several factors:
You can deposit that money at a bank
Purchase an investment that will yield you a return for the next year. The present value is discounted by the rate of return you could earn on that dollar over the next year (the discount rate). Our example represents a one-time future payment, but the concept is the same for bonds that represent a stream of future payments. The discount rate for a bond is its yield.
The price of a bond is a function of the coupon of the bond relative to the market yield of equivalent bonds. For example, a bond with a coupon rate of 5% will be priced at par if the market yield is also 5%, if the market yield is below 5%, the bond will trade at a premium, and if the market yield is above 5% the bond will trade at a discount.
Since bond prices fluctuate with changes in market yields or the general level of interest rates, in order to determine the factors that influence bond prices we need to understand what factors influence the general level of interest rates.
Posted by John Adams on 