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Understanding the Factors that Influence Bond Prices
Bond investments represent an important asset class available to investors. Thus, understanding the key factors that influence bond prices will help investors better manage their overall investments.
Bonds are debt instruments issued by corporations for a period of more than one year for the purpose of financing their capital expenditures. Bonds can be issued by governments, quasi government institutions, financial institutions, corporations and other types of institutions.
Bond investors receive interest payments which are called coupon payments. At the end of the bond’s maturity period, investors will receive the principal repayment. The value of a bond is the present value of the stream of cash flows comprising coupon payments and principal repayment. This valuation is obtained by discounting the bond’s expected cash flows to the present using an appropriate discount rate. The discount rate used should be reflective of current market yields for bonds with similar maturities and credit rating.
To illustrate the computation of a bond’s value, the example shown in Table 1 is used. A 5-year AA-rated Corporate Bond has a coupon rate of 4.50% and matures in 5 years with a maturity value or par value of RM1,000. A discount rate of 5%, which is reflective of current market yields for similar bonds, is used to discount the bond’s cash flows.
Cash flows from coupon payments received at the end of each of the five years are shown in column A of Table 1. At the end of the fifth year when the bond matures, the principal repayment is received as shown in Column B. The total cash flows received by the bondholder which is the sum of Column A and B are shown in Column C. The discount factor which is used to discount the bond’s cash flow is shown in Column D. The net present value of the stream of cash flows (Column E) is obtained by multiplying the cash flow received by the respective discount factors for each year.
Table 1: Computing the Net Present Value of Cash Flows of a 5-year AA-rated Corporate Bond | |||||
Coupon | Principal Repayment | Total Cash Flows | Discount Factor* | Net Present Value of | |
(RM) | (RM) | (RM) | (RM) | ||
[A] | [B] | [C] | [D] | [E] = [C] x [D] | |
Year 1 | 45 | - | 45 | 0.952 | 42.86 |
Year 2 | 45 | - | 45 | 0.907 | 40.82 |
Year 3 | 45 | - | 45 | 0.864 | 38.87 |
Year 4 | 45 | - | 45 | 0.823 | 37.02 |
Year 5 | 45 | 1,000 | 1,045 | 0.784 | 818.78 |
Total: | 225 | 1,000 | 1,225 | 978.35 | |
*The discount factor is the inverse of the discount rate compounded by the respective
year in which the cash flow is received.
Based on a discount rate of 5%, the value of the 5-year bond bearing a coupon rate of 4.5% should be equal to the total net present value of its cash flows of RM978.35.
During the life of a bond, its price or valuation may change depending on various factors which include the following:
1. Change in Interest Rates
The price of a bond moves inversely to market interest rates. This relationship is due to the fact that the discount rate used to compute the net present value of cash flows from a bond is based on prevailing market interest rates. When market interest rates move up, the discount rate of a bond rises, causing the value of the bond to fall as the cash flows are discounted at a higher discount rate. Conversely, a bond’s value rises when market interest rates decline as the corresponding cash flows are discounted at a lower discount rate.
2. Bond Coupon Rate
Most bonds have a fixed coupon rate over the tenure of the bond. Coupon payments are typically paid out semi-annually or annually. In the earlier example, the bond has a face value of RM1,000 with a coupon payment of RM45 per year, giving an annual coupon rate of 4.50%.
If a bond's coupon rate is below the market yield, the bond will trade below its par value i.e. at a discount. This happens because investors will require the yield of the bond to be in line with existing market yields. This means the bond price will decline to the level where its yield is equivalent to current market yields of bonds of similar credit ratings and maturities.
If a bond's coupon rate is above the market yield, the bond will trade above its par value or at a premium. This occurs as investors are willing to pay a higher price to achieve the additional yield. Remember that as the yield decreases, the bond’s price increases.
3. Bond Maturity
The prices of bonds with a longer term to maturity are more sensitive to changes in interest rates. Prices of bonds with longer maturities will decline by a larger magnitude as compared to bonds with shorter maturities when interest rates rise. Similarly, prices of bonds with longer maturities will rise by a larger magnitude as compared to bonds with shorter maturities when interest rates decline.
4. Bond Credit Rating
Thebond credit ratingsystem helps investors to determine the issuer’s credit risk profile. A higher credit rating indicates that the issuer has a stronger capacity to service the bond’s coupon payments or principal repayment on a timely basis, while a lower credit rating indicates a weaker capacity of the issuer to service its coupon payments and principal repayment. Hence, bond issuers with lower credit ratings have to offer higher yields to attract investors given the higher risk involved and vice versa.
A change in a bond’s credit rating can impact a bond’s price. If the bond’s credit rating is lowered, the value of the bond will decline and its yield increases. Alternatively if the credit rating is raised, the value of the bond will rise and the yield declines.
Despite changes in a bond’s valuation due to movements in interest rates over the life of a bond, an investor who holds a bond from issue date to maturity will receive the total amount of coupon and principal repayment as originally stipulated over the life of a bond. Similarly, long term investors in bond funds will be able to ride through fluctuations in bond valuations as a result of movements in interest rates as the fund will receive the coupons and principal repayments held by its bond portfolio in full over the longer term.
In summary
Building a portfolio for savings and eventual retirement involves carefully selecting the appropriate portfolio of investments to achieve your financial goals. Bond investments can help create a savings pool, generate interest income and stabilise the overall performance of an investment portfolio.
In view of potential movements in bond prices, it is advisable that investors have an understanding of the factors which impact the value of bond investments. Investors should be aware that they need to take a longer term perspective when investing in bonds or bond funds. Although changes in market conditions such as interest rates may result in fluctuations in bond valuations, such fluctuations should even out over the longer term.
This article is prepared solely for educational and awareness purposes and should not be construed as an offer or a solicitation of an offer to purchase or subscribe to products offered by Public Mutual. No representation or warranty is made by Public Mutual, nor is there acceptance of any responsibility or liability as to the accuracy, completeness or correctness of the information contained herein.
