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

Imagine you are reviewing a new corporate bond issuance from a major infrastructure firm in India. Your firm’s research desk notes that while the bond carries a 7.5% annual coupon, the broader market for comparable debt instruments has shifted, causing the YTM to climb to 8.2%. As an analyst, you immediately recognize that the bond must be priced at a discount. This intuition is not just academic; it is the fundamental mechanism that ensures a bond’s total return aligns with the prevailing risk-adjusted requirements of the market.

The relationship between the Coupon Rate (CR), Current Yield (CY), and Yield to Maturity (YTM) acts as a compass for bond pricing. The CR represents the fixed annual payment based on face value, essentially the ‘promised’ return at issuance. In contrast, the CY provides a snapshot of the return based specifically on the current market price, calculated as the annual coupon divided by the market price.

The YTM is the comprehensive metric, representing the internal rate of return if the bond is held until maturity, incorporating both interest payments and the capital gain or loss resulting from the discount or premium price.

Consider an Indian government bond with a face value of ₹1,000, a coupon of ₹70, and a market price of ₹950. Here, the CR is 7%, but the CY is approximately 7.37% because you are paying less than par for the same coupon stream. If the bond matures in five years, the YTM will be even higher than the CY, as it accounts for the ₹50 gain you realize when the issuer redeems the bond at its full face value.

This systematic alignment ensures that regardless of whether a bond trades at a discount or premium, the total yield to the investor remains competitive with market benchmarks.

For an investment adviser, these metrics provide immediate insight into market sentiment. If a bond’s CY is higher than its CR, the security is trading at a discount, signaling that market interest rates have risen since the bond was issued. Conversely, if the CY is lower than the CR, the security trades at a premium, suggesting market rates have fallen.

By monitoring these relationships, you can quickly assess whether an asset is attractively priced for a client’s portfolio without needing to run a full discounted cash flow model for every trade.

Nuance

⚠️ Nuance
Candidates often erroneously assume that a bond’s Current Yield is a proxy for its total return, leading them to ignore the significant impact of the bond’s maturity date. While the CY is helpful for quick assessment, it fails to account for the ‘pull-to-par’ effect, where a bond’s price converges to its face value as maturity approaches. An analyst who relies solely on CY may significantly misprice the risk of long-duration bonds, where the capital gain or loss component of the YTM is far more influential than the annual coupon payment.

Check Your Understanding

Practice Question 1

An analyst observes a non-callable bond with a face value of ₹1,000 and an annual coupon of ₹80. The bond is currently trading at ₹920. Which of the following statements regarding the yields is correct?

Practice Question 2

Which relationship must hold true for a bond trading at a premium in the market?

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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