📚 PASS Investment Adviser (Level 1) Difficulty: Intermediate ℹ️ Info   ~5 min read
📌 Chapter 9.4 — Pricing of Bond

Imagine you are reviewing a corporate bond issuance by a leading infrastructure firm in the Indian market. While the perpetual bond we analyzed previously offers a simple infinite stream, most corporate debentures you will encounter in your professional practice have a fixed maturity date. As an analyst, your task is to forecast the cash flow profile until the redemption date, incorporating both the periodic interest payments and the return of the face value.

This transition from infinite to finite cash flows fundamentally changes how you assess price sensitivity and yield-to-maturity (YTM).

Valuing a standard bond requires the summation of the present values of all future coupons plus the present value of the principal repayment at maturity. Unlike perpetuities, the principal repayment—the face value—acts as an ‘anchor’ for the bond’s price.

As the bond approaches its maturity date, the market price must converge toward the par value, a phenomenon known as ‘pull-to-par.’ This is critical for portfolio managers because it implies that, all else being equal, the price volatility of a bond decreases as the time to maturity shortens, effectively reducing the interest rate risk exposure.

Consider an Indian company issuing a 5-year, 8% coupon bond with a face value of ₹1,000, while the prevailing market interest rate for similar credit risk is 9%. Because the coupon is lower than the market rate, the bond must trade at a discount to compensate the buyer. Using a financial calculator or an Excel spreadsheet, you discount each of the five annual interest payments and the final ₹1,000 principal repayment at the 9% rate.

The resulting clean price will be below ₹1,000, reflecting the present value of the difference between the 8% coupon and the 9% required return.

In practical research, this finite valuation model allows you to perform sensitivity analysis on changing interest rate environments. If your macro outlook suggests the Reserve Bank of India might hike repo rates, you can stress-test the bond’s price by adjusting the discount rate in your model. A professional analyst uses this finite framework to determine if a bond is ‘cheap’ or ’expensive’ relative to its peers.

Ultimately, your recommendation hinges on this calculation, as it identifies the margin of safety between the current market price and the intrinsic value derived from your discounted cash flow model.1

Nuance

⚠️ Nuance
Candidates often fall into the trap of assuming that a bond’s price will move linearly with changes in interest rates, forgetting the ‘convexity’ effect inherent in finite-maturity instruments. Because the discount rate is applied as an exponent in the present value formula, the relationship between price and yield is curved rather than straight. When performing valuations, always remember that price changes are more pronounced when yields are low, and this effect is compounded as the bond’s duration increases.

Check Your Understanding

Practice Question 1

A 3-year bond with a face value of ₹1,000 pays an annual coupon of 7%. If the current market yield is 9%, what is the approximate price of the bond? (Use PV factors: 9% for 1yr=0.917, 2yr=0.842, 3yr=0.772)

Practice Question 2

Which of the following factors would lead to a smaller price change in a bond for a given change in interest rates?

This is a companion read for Section 9.4 — Pricing of Bond from PASS Investment Adviser (Level 1) by Akhilesh Gururani, available on Amazon Kindle.

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  1. The discount rate used is typically the YTM, which assumes the bond is held to maturity and all coupons are reinvested at that same rate. ↩︎