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

Imagine you are reviewing a portfolio for an institutional client in India. You notice two corporate bonds issued by leading infrastructure firms: one is trading at 98.50 and the other at 104.25. As a research analyst, your immediate task is to interpret these prices relative to their par value of ₹100.

This is not merely a mathematical exercise; it is an assessment of the issuer’s current credit spread and the prevailing interest rate environment relative to the bond’s original coupon rate. Understanding why a bond trades at a discount or premium is the first step in diagnosing its yield-to-maturity profile.

A bond trades at par when the coupon rate is exactly equal to the prevailing market yield for that specific maturity and risk profile. When the market interest rate for similar risk instruments rises above the bond’s coupon rate, the bond becomes less attractive, forcing its price to fall below par to compensate investors.

Conversely, if market interest rates drop below the bond’s coupon rate, the bond offers a superior yield compared to new issuances, driving its price to a premium. This mechanism ensures that the bond’s effective yield consistently aligns with market conditions.

Consider a case where the Reserve Bank of India (RBI) initiates a repo rate cut. Existing bonds with higher coupon rates suddenly become highly desirable, and their market price will climb above face value. For instance, if you hold a bond with a 9% coupon and market rates for comparable debt fall to 7.5%, your bond will trade at a premium because buyers are willing to pay extra for the locked-in higher cash flows.

This price appreciation is the market’s way of normalizing the bond’s yield to the new, lower interest rate environment.

In your valuation models, distinguishing between these price points is essential for calculating the ‘yield-to-maturity’ (YTM) accurately. A bond trading at a discount offers both interest income and a capital gain as the bond converges to par at maturity. A bond at a premium, however, will see its value slowly erode toward par as maturity approaches, which must be factored into your total return expectations. Ignoring these shifts can lead to significant errors in cash flow projections and risk assessments, especially for portfolios sensitive to interest rate volatility.

Nuance

⚠️ Nuance
Many candidates incorrectly assume that a premium bond is inherently ‘better’ than a discount bond because of the higher coupon rate. In reality, the market pricing mechanism already accounts for this by discounting the future cash flows. A professional must look beyond the coupon and recognize that price is simply the market’s mechanism to equalize total return across various debt instruments, regardless of their nominal coupon.

Check Your Understanding

Practice Question 1

An NCD issued by a power company has a face value of ₹1,000 and pays an annual coupon of 8.5%. If the prevailing market yield for similar risk instruments is 9.2%, how will this bond be priced in the secondary market?

Practice Question 2

Which of the following scenarios describes a situation where a bond would trade at a premium?

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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