Bond price, or bond value, is the maximum amount an investor is willing to pay to purchase a bond. Bond pricing is impacted by the current average interest rate at which returns are being generated by investors and the interest rate listed on the bond. A bond is priced at:
Par Value: equivalent to its face value.
Premium: higher than its par value. Its interest rate is higher than that prevailing in the market.
Discount: lower than its par value. It has an interest rate that is lower than the current interest rate in the market.
Standard Methods for Listing Bond Prices
Bond values are listed in terms of:
Dollar Price: This refers to the percentage value of the bond’s par value. For example, if a two-year treasury bond is quoted at 99-30½, '99' is the handle (or whole dollar value). To convert the quote into a percentage, 30½ (30.5) is divided by 32 and the quotient (0.953125 in this case) is added to the handle (99). Hence, the amount at which the bond is bought is 99.953125% of the face value of the bond.
Yield: This has an inverse relationship with bond prices. When yield rises, bond prices decline and vice versa. An estimation of the income streams from a bond that has periodic coupon payments and the reimbursement of the par value on maturity are crucial for the calculation of bond prices.
Arithmetically speaking, bond price is the sum of the current value of tentative coupon payments and the current value of the face value at maturity. The equation given below can be used to calculate bond price:
Bond Price = P/(1+r) + P/(1+r)^2 + P/(1+r)^n + V/(1+r)
P = Coupon Payment
n = Number of Payments
r = Required Yield or Interest Rate
V = Par Value or Final Value at Maturity
Bonds are also priced relative to a benchmark, generally a government bond. A bond's yield in relation to the yield of its benchmark is called a spread. The spread is used not only for pricing purposes, but also to compare various bonds. A detailed understanding of bond prices and their movement is a prerequisite to maintaining a profitable portfolio.