Analysis of Asset Allocation

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Bonds - Major characteristics: Price and Yields
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Price and yield: pay the right price for your bond

The price you pay for your bond depends of variables: interest rate, maturity, credit quality, tax status, ... The price is generally expressed in percentage of the face value. Unless you purchase your bond during the offering period or at the coupon's date, you have to add to this percentage the accrued interests since the last coupon's date.

If the bond's price is over 100% (over face value), it is said to be selling at a premium. If the bond's price fells below 100%, it is said to be selling at a discount.

But how is the price fixed?

Before answering that question, we must introduce the notion of yield. Yield can be defined as the return you get based on the price you pay and the interest you receive. Of course, depending of what you want to measure, you have different yields. They will be analyzed in the yield section.

In general prices are linked to yields (not exclusively because we have already seen that it was also linked to credit quality).

From the moment a bond is issued up to the moment it matures, its price on the market will fluctuate according to changes in market rates (and credit quality). For the time being, we will not take care of the influence of the credit quality on the price. The price you pay reflects the present yield on the market compared to the interests paid by the the bond.

If the present yield is lower than the interests paid by the bond, the price will be over 100%. Let's assume that at current market conditions, you can lend money for 5 years at 6%. If the bond pays you an interest of 10%, you will pay more than the redemption value (more than 100%) to reflect the fact that you get an higher interest. You will pay less than 100% if the bond bears only an interest of 5%.

From the above we can conclude that when interest rates rise on the market, bonds' prices fall and when interests rates fall, bonds' prices rise.

One of the advantages of a bond is that, if you need the money, you can sell it to another investor before the maturity but you must be aware the the price you will get depends of the market conditions at the sale date (can be higher or lower than the redemption value).

In the next section, we will study the different yields.

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