When it comes to bonds, there are two types of "pricing" an investor needs to understand. The first is the initial price of the bond – or its face value – which is set when the bond is first issued to the market. This is also the amount of capital that will be returned to the investor at maturity barring a default.

The second relates to the price of the bond as it trades in the secondary market. Such prices are quoted as a percentage of the bond’s face value. For example, if the face value is Rs1000 and the quoted market price is Rs 990, then the bond price is quoted as 99. Similarly, if the market price is Rs 1010, the bond is trading at a price of 101.

When the bond price is higher than its face value, it’s described as trading at a premium to par. On the other hand, when the bond price is lower than its face value, it is said to be trading at a discount to par.

This concept is illustrated in the table below:

Bonds have several common aspects that investors should be familiar with, including:

• Issuer Any legal entity that seeks to raise money by selling securities such as bonds to fund new projects or investments, or to expand operations.
• Face value Also known as "par value," this is a static value assigned when a company brings stock or a bond to market. Unlike market value, face value doesn’t change. You’ll find the par value printed on the stock or bond certificate.
• Coupon rate The nominal or stated rate of interest on a fixed-income security, like a bond. This is the annual interest rate paid by the bond issuer, based on the bond’s face value. These interest payments are usually made semiannually.
• Issue date The issue date is the date on which a bond is issued and begins to accrue interest.
• Maturity date The date on which you can expect to have your bond's principal repaid. It is possible to buy and sell a bond in the open market prior to its maturity date. Keep in mind that this changes the amount of money the issuer will pay you as the bondholder, based on the current market price of the bond.
• Price As a bond's price fluctuates, the price is described relative to the original par value, or face value at which it was sold; the bond is referred to as trading above par value or below par value.
• Yield The discount rate that links the bond's cash flows to its current dollar price.

Bonds can provide a means of preserving capital and earning a predictable return. Bond investments provide steady streams of income from interest payments prior to maturity.

The interest from municipal bonds generally is exempt from federal income tax and also may be exempt from state and local taxes for residents in the states where the bond is issued.

• Credit risk The issuer may fail to timely make interest or principal payments and thus default on its bonds.
• Interest rate risk Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.
• Inflation risk Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.
• Liquidity risk This refers to the risk that investors won’t find a market for the bond, potentially preventing them from buying or selling when they want.
• Call risk The possibility that a bond issuer retires a bond before its maturity date, something an issuer might do if interest rates decline, much like a homeowner might refinance a mortgage to benefit from lower interest rates.

If you want to allocate a portion of your portfolio to bonds, you could buy individual bonds or purchase a mutual fund that invests in bonds.

A right choice is depends on your ability and interest in researching your initial investments, your willingness to track them on an ongoing basis, the amount of money you have to invest, and your tolerance for different types of risk.

Bond mutual funds or debt funds are just like stock mutual funds in that you put your money into a pool with other investors, and a professional invests that pool of money according to what he or she thinks the best opportunities are, in accordance with the fund’s stated investment goals.

Investors who plan on holding their bond until maturity typically don’t need to worry about the movement of bond prices on the secondary market as they will be repaid their Principal in full at maturity, barring a default. But for those looking to sell their securities sooner, an understanding of what drives secondary market performance is essential.

The price of a bond relative to yield is key to understanding how a bond is valued. Essentially, the price of a bond goes up and down depending on the value of the income provided by its coupon payments relative to broader interest rates.If prevailing interest rates increase above the bond’s coupon rate, the bond becomes less attractive. In this situation, the bond price drops to compensate for the less attractive yield. Conversely, if the prevailing interest rate drops below the bond’s coupon rate, the price of the bond goes up as it becomes more attractive.

For example, if a bond has a 4% coupon and the prevailing interest rate rises to 5%, the bond becomes less attractive and so its price will fall. On the other hand, if a bond has a 4% coupon and the prevailing interest rate falls to 3%, that bond becomes more attractive which pushes up its price on the secondary market.

• Financial health of the issuer
• Inflation
• Market conditions
• Ratings
• The age of a bond

A bond's yield refers to the expected earnings generated and realized on a fixed-income investment over a particular period of time, expressed as a percentage or interest rate. The simplest way to calculate a bond yield is to divide its coupon payment by the face value of the bond. This is called the coupon rate or coupon yield.

Coupon Rate = Annual Interest Payment / Bond Face Value

However, if the annual coupon payment is divided by the bond's current market price, the investor can calculate the current yield of the bond. Current yield is simply the current return an investor would expect if he/she held that investment for one year, and this current yield is calculated manually or by yield calculator, online, dividing the annual income of the investment by the investment's current market price.

Coupon Rate = Annual Interest Payment / Bond Market Price.

Yield to maturity (YTM) is the overall interest rate earned by an investor who buys a bond at the market price and holds it until maturity. Mathematically, it is the discount rate at which the sum of all future cash flows (from coupons and principal repayment) equals the price of the bond. Yield to Maturity (YTM) is often quoted in terms of an annual rate and may differ from the bond's coupon rate. It assumes that coupon and principal payments are made on time. Further, it does not consider taxes paid by the investor or brokerage costs associated with the purchase.

Let’s take an example

A company or financial institution may need money to expand their business, build a new plant, purchase machinery, buy new land or acquire another company.

One of the ways to raise money is to issue bonds.

Let’s examine this. On February 28, 2020, corporate Atul Industries issued bonds of Rs 10 lakh each with a 10-year maturity, and a coupon of 9.18%.

• Face Value, or Par Value The FV is the value assigned to the bond. This is the amount of money loaned to the issuer and it will be returned to the lender on maturity. This is static. In this example is Rs 10 lakh.
• Maturity This is the length of time of the financial contract. In this case, it is 10 years. So the investor who bought a bond would be loaning Atul Industries Rs 10 lakh for a period of 10 years.
• Coupon Rate Now the investor needs to get compensated for lending his money. The CR is the annual rate of interest that could be paid semi-annually or annually. This is static, in the sense that it is fixed when the bond is issued. In this example it is 9.18% of Rs 10 lakh every year, over 10 years.

So what happened here?

When you buy a bond, you lend money to the company that issued the bond (issuer). In exchange, the company makes a legal commitment to return your money (principal) on a predetermined date (maturity date), and till it does so, it will pay you a specified rate of interest (coupon rate) on predetermined dates.

Whether the company makes profits or incurs losses, or its stock price rises or falls, that is irrelevant to the terms and conditions. It still has to pay the coupon rate promised and return the principal on the specified date.

Understand Yield.

During these 10 years, the bond will be traded in the market. As with any instrument traded, the price will rise or fall. As that happens, the market price of the bond will differ from the Face Value (FV). But since the Coupon Rate (CR) is static, and is a percentage of FV, the return will differ. This return is called yield.

Let’s work it out.

• FV = Rs 100
• CR = 5% p.a
• Amount investor earns every year = Rs 5 (5% of Rs 100 is Rs 5)

In the market, the price rises to Rs 110. A buyer is paying more than the FV of Rs 100. However, return is still Rs 5 per annum. Rs 5 on Rs 110 = 4.55%. So the bond yield has fallen because the bond price has risen.

In the market, the price falls to Rs 90. A buyer is paying less than the FV of Rs 100. However, return is still Rs 5 per annum. Rs 5 on Rs 90 = 5.55%. So the bond yield has risen because the bond price has fallen.

Did you get it?

Yield is the return you get by applying the CR to its market price. It is the return you will get when you buy the bond at that given price and hold it till maturity.

As you can see, the yield rises because the bond price has fallen. Or the yield falls because the bond price has risen. There is an inversely proportional relationship between the two. As interest rates go down, bond prices go up (+ve return) and as interest rates go up, prices go down (-ve return).

This inverse relationship is quite intuitive.

Let’s take the above example of a coupon of 5%. When interest rates are trending downwards (say in the region of 4.55%), a bond paying a coupon 5% would be more valuable. As demand for the bond increases, the price of this bond will move higher. The reverse will take place when interest rates increase. This time, bonds with lower coupon become less valuable and so the bond prices fall accordingly.

YTM is yield to maturity.

YTM is the estimated annual rate of return for a bond assuming that the investor holds the asset until its maturity date and reinvests the payments at the same rate as its current yield.

So it depends on the price you paid when you purchased the bond - if it was on par or at a premium or a discount. The interest you will earn during the balance period. And the assumption that this interest will be reinvested at the same yield. In other words, YTM accounts for the present value of a bond’s future coupon payments. Put together, these are the components of YTM.

The formula for calculating YTM is:

conclude:

• Return in case of bonds is the combined effect of coupon (interest) rate + capital appreciation.
• As with any instrument traded, the price will rise or fall since the cash flows over the life of this fixed-rate bond are fixed.
• Rising interest rates lower the attractiveness of these fixed cash flows due to the higher discounting rate. Falling interest rates increase the attractiveness of these fixed cash flows due to the lower discounting rate. (Discounting rate is the interest rate applied to determine the present value of these cash flows).
• The higher market price of the bond (relative to FV) is the result of an adjustment reflecting lower market interest rates. The lower market price of the bond (relative to FV) is the result of an adjustment reflecting higher market interest rates.