Economics
Bond Pricing
Quick fact
A bond's price is not fixed; it fluctuates inversely with its yield. For example, when interest rates in the economy go up, existing bond prices go down. This inverse relationship is the core of bond pricing.
Why this is interesting
Bonds are often thought of as 'safe' investments, but their prices can rise and fall daily—even though the issuer promises to pay back a fixed amount. How can a bond's price change when its face value stays the same?
Read the full explanation
Understanding Bond Pricing
Imagine a bond as a loan that you, the investor, make to a government or corporation. The bond has a face value (say $1,000) that you get back on a specific maturity date. In the meantime, it pays you a fixed interest payment called a coupon (e.g., $30 per year). But the price you pay for that bond today is not just $1,000—it depends on what other investments are offering. If similar new bonds pay a higher interest rate, your bond's fixed coupons become less attractive, so its price falls. To calculate the fair price, we sum up the present value of all future cash flows (coupons and face value) discounted at the market's required yield. This process is called discounting. The bond's price is simply the total of those discounted cash flows. For example, if a bond pays $30 annually for five years and $1,000 at maturity, and the market yield is 4%, the price is the sum of $30/(1.04)^1 + $30/(1.04)^2 + ... + $30/(1.04)^5 + $1,000/(1.04)^5. The result will be above or below $1,000 depending on whether the coupon rate is higher or lower than the market yield.
A deeper explanation
The mechanism behind bond pricing is the time value of money: a dollar received in the future is worth less than a dollar today because you could invest it and earn a return. Discounting converts future amounts into today's equivalent. The market yield—also called the yield to maturity—is the annual return investors demand to hold the bond. This yield reflects prevailing interest rates, inflation expectations, and the creditworthiness of the issuer. Crucially, bond price and yield move inversely: when yields rise, the present value of future cash flows falls, so the bond's price drops. This is why bondholders face interest rate risk. The coupon rate determines the bond's income stream, but the market yield determines its price. When the coupon rate equals the yield, the bond trades at par (face value). When the coupon is higher, the bond sells at a premium; when lower, at a discount. Understanding this pricing relationship helps investors assess relative value, manage risk, and choose bonds that fit their return and income needs.