Corporate bonds are crucial financial instruments for both business and individual investors. They allow corporates to raise capital from the investors in return for fixed interest payments. They are categorised into secured and unsecured based on the collateral backing they offer to protect an investor in case of a default. Many factors, like the coupon rate, bond yield, the bond’s creditworthiness, time to maturity, etc., govern the bond prices.
Let us discuss how corporate bonds are priced and the factors determining their price variations.
Investors must understand the functioning of the bonds as they trade differently from equities. While the equities are traded in the secondary market based on their predicted future value, bonds may trade at, below, or above their face value, depending on various market conditions. The interest rate on the bonds is predetermined, but with the change in the bond prices, bond yield changes, which refers to the annual interest compared to the current market price.
Just like the interest rate in fixed deposits, bonds also have a fixed interest rate known as a coupon rate, which is declared on the face value of the bonds and generally remains the same till it matures.
Similar to equity being traded on the secondary market post IPO, bonds post their issue, enter the secondary market and trade according to demand and supply forces, determining their current price. The total return an investor can expect from holding the bond is reflected in its yield.
For example, if you purchase a 10-year bond of INR 10,000 with a coupon rate of 7.5%, the bond will pay you INR 750 every year until it matures after ten years.
The bond yield is not fixed and may differ based on the bond's current price in the secondary market, which is influenced by demand and supply dynamics. For instance, if the bond's current market price is higher than its face value, say INR 12,000, the yield will differ from the coupon rate.
To calculate the yield, you would divide the annual coupon payment (INR 750) by the current market price (INR 12,000) and express it as a percentage. In this case, the yield would be approximately 6.25% [(750/12,000) * 100].
Conversely, if the bond's market price is lower than its face value, say INR 9,000, the yield will be higher than the coupon rate. Similarly, the yield would be approximately 8.83% [(750/9,000) * 100].
In the secondary market, bond yields depend on demand and supply. Bond yield has an inverse relationship with bond prices. As in the above example, if the interest rates in the secondary market rise above 7.5%, investors will not buy bonds but can invest in new bonds with an interest rate of more than 7.5%.
In this case, the issuer has to lower the bond's price to increase its yield. When lowering the bond's price, the yield increases because you are getting the same coupon payment for a lower price, which increases the bond’s yield. The coupon rate remains the same as it is fixed when the bond is issued.
The market value of the bonds is not crucial for the primary investors who wish to hold the bonds till they mature because they aim to receive regular interest payments and the principal at maturity. However, the market value is essential for investors who wish to trade bonds in the secondary market. Let us have a look at the factors influencing bond prices:
Investing in bonds allows you to grow your wealth as it brings stability to your portfolio by generating regular interest payments. Understanding the factors affecting bond prices will enable you to make smarter investing decisions. You can explore corporate bonds offering inflation-beating returns with the curated investment opportunities at Grip Invest.
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