The current market price of bonds is the present value of all future cash flows, discounted by a suitable interest rate. To get the current market value bond price, you use a discount rate equal to the prevailing yields on similar bonds.
The price of a bond fluctuates in response to changes in the current interest rates. At maturity, the bond pays you its face value (or par), which may be different from the purchase price or the current price. Rising interest rates hurt bond prices while falling rates boost prices.
Investing in Bonds
Corporations and governments issue most bonds. Normally, the stated interest rate is fixed for the lifetime of the bond. Bonds typically pay interest semi-annually, but other frequencies are possible. The total return on the bond is the sum of the interest payments and the payment of the face value at maturity.
The current market price of a bond is the present value, or PV, of the total return calculated from future cash flows. The discount rate used in the PV calculation depends in part on current interest rates, which is the link between price and interest.
Read More: What Determines Bond Prices?
Using an Online Price Calculator
The easiest way to calculate a bond price is to use an online bond price calculator. The inputs are:
- Face value: The principal amount the bond will repay at maturity – also called par value.
- Annual coupon rate: The amount of interest paid out annually divided by the face value.
- Discount rate: The market yield you can obtain from other bonds with similar characteristics.
- Years to maturity: The number of years until the bond repays its principal.
- Days since last payout: The date of the previous coupon payment.
- Frequency: How often the bond pays interest.
Example Bond Price Calculation
Suppose you want to calculate the current price of a $1,000, 7 percent semi-annual bond that has nine years left until maturity. The coupon rate tells you that bond interest of $35 is paid semi-annually. The bond last paid interest 54 days ago. Currently, the market yield for similar bonds is 8 percent.
Load the data into the price calculator as follows:
- Face value: $1,000
- Annual coupon rate: 7 percent
- Discount rate: 8 percent
- Years to maturity: 9
- Days since last payout: 54
- Frequency: Semi-annual.
The calculator will return two prices:
- Clean price of $936.70. Clean price ignores any interest that accrued since the last payment date. Bonds are quoted in terms of clean price.
- Dirty price of $947.20. Dirty price includes the accrued interest you’ll receive at the next payment date. Dirty price is the amount you would have to pay to buy the bond today.
Notice that the price is less than the face value. This is because the relatively low coupon rate requires a lower price to provide a yield competitive with similar bonds. If the coupon rate happens to equal the market rate, the clean price would equal the face value (i.e. $1,000).
Read More: How to Calculate Accrued Interest on Bonds Purchased
Rate/Price Inverse Relationship
The inverse relationship between interest rates and market value bond prices stems from competition in the bond market for investors’ money. A bond that pays 7 percent, or $70 a year on a $1,000 face value, will seem unattractive if companies are now issuing similar bonds paying 8 percent. Since the bond’s interest rate is fixed, the only way to make the 7 percent more attractive is to lower its price so that its yield, or interest divided by price, rises to about 8 percent.
Bond Pricing Factors
Several factors affect a bond’s convexity, which is the sensitivity of its price to interest rate changes. One factor is the bond’s duration, or payback period. The faster you get paid back, the less risk you’ll experience from interest rate moves and the lower the bond’s convexity.
Read More: How to Calculate Modified Duration
Low-quality, or junk, bonds may be highly sensitive to interest rate hikes because investors may fear that the issuer might have trouble borrowing additional money to pay the interest and principal on the junk bond. Other price factors include the time until maturity and whether the issuer can redeem the bonds before maturity.
Notwithstanding the calculation results and price factors, a bond's actual current price is determined by the continuous auction process on public bond exchanges.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.