How to Calculate Bond Prices
Bonds are similar to the CDs (Certificates of Deposit) we buy to earn good interest rates on our savings. When you purchase a CD, you are loaning the money to a bank until the CD matures, at which time you get your money back, plus interest. However, bonds are issued by corporations and by governments at the national, state or local levels. In addition, bonds can vary in price as they are traded on financial markets. This can be confusing for many people because the price of a bond is usually different from its face (or par) value. So, how do you calculate the price of a bond? The answer is that you don't. Instead, you look it up. What people usually mean when they say they want to calculate the price of a bond is that they want to calculate the interest rate or yield of a bond. It's important to know how that price is arrived at, how it affects the interest rate you earn, and what all this says about the bond as a good or bad investment.
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Instructions
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Begin by understanding how a bond works. Corporations and governments issue bonds to borrow money. Corporate bonds most often have a face (or par) value of $1,000 (government bonds vary from as low as $100 for municipal bonds to $10,000 or more for U.S. Treasury bonds). The par value is stated on the bond and is the amount of money the issuer will pay at when the bond matures to retire the debt. Each bond also has a coupon rate, which is the amount of interest the bond pays you each year. For a bond with a par value of $1,000, if the coupon rate is 10 percent, you would receive $100 each year you own that bond.
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Learn how bond prices are arrived at. The par value is not the price of the bond. Bonds are traded like stocks, and the prices are set by market factors, by how much the bond earns and by how much risk the investment has. The first thing to know is that if the coupon rate is higher than the prevailing interest rates, the bond's price will tend to rise above the par value (we say the bond is traded a at premium). If, on the other hand, interest rates rise above the par value, the price of the bond tends to fall below its face value--the bond is purchased at a discount.
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Know the other factors that affect a bond's price. The first is how long the bond is issued for. If a bond matures in just a couple of years, it has less risk than a bond that doesn't mature for 30 years. This is simply because there's more uncertainty about what will happen in 30 years than in one or two years. All else being equal, a long-term bond will have a lower price and greater interest yield than a short-term bond because of the greater risk.
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Understand that the reputation and financial condition of the bond issuer affects bond prices. That's crucial because a bond issuer with poor financial prospects is less likely to be able to redeem (pay off) the bond when it matures. Bonds are rated according to their risk. You can check bond ratings with Moody's or another bond rating service. "Blue chip" bonds--those with low risk--tend to have higher prices and lower interest rates. High-risk bonds (also called "junk bonds") are much riskier. They tend to be low priced and very high interest rates, but there's a significant chance you won't get your money when the bond matures.
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Put this all together. When you look up the price of a bond in the newspaper or online, that price is the result of all the factors mentioned above. But you need to understand the bond's yield. No matter what its price, the bond still pays the same coupon rate. If the price rises, the coupon rate will give you a lower interest rate (yield) than what you'd get if you bought the bond at face value. The reverse is also true. If you buy a bond at a discount, the yield will be higher than the coupon rate. But how do you calculate the interest rate or yield? In practice, you use a yield calculator. There are many free ones available online.
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Tips & Warnings
If you want to invest in bonds, realize that the market will calculate the price of the bond based on many factors. Price can be affected by other factors than the ones discussed above. If investors expect interest rates to rise, bond prices are likely to fall.
Sometimes, counterintuitive as it is, bad economic news can make bond prices rise. The reason is that the Federal Reserve (or the central bank in another country) may cut interest rates to try to stimulate the economy. But when interest rates drop, bond prices tend to go up. So if you own bonds and this happens, the bad economic news can be good news for you.
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