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

Imagine you are reviewing a corporate bond issuance from a major Indian infrastructure conglomerate on your Bloomberg terminal. The bond carries an 8.5% coupon, but you notice it is currently trading at 98.20 against its face value of ₹100. As a research analyst, your immediate task is to reconcile why this security is trading at a discount.

You recognize that the market yield, or the Required Rate of Return (RRR) for investors, must be higher than the coupon rate, effectively rendering the bond’s fixed payments less attractive compared to new debt issues hitting the market.

This pricing divergence occurs because the bond’s cash flows are fixed at the time of issuance, while market interest rates are fluid. When the prevailing market yield rises above the bond’s coupon rate, the present value of those future cash flows decreases, forcing the bond price to fall below par to compensate investors with a capital gain at maturity. Conversely, if market rates drop below the coupon rate, the bond becomes a yield-generating asset in high demand.

Investors will bid the price up above par—a premium—until the yield on that purchase price aligns with the current market interest rate.

Consider an Indian Government Security (G-Sec) that was issued five years ago with a 7% coupon when the broader interest rate environment was lower. If current RBI policy adjustments or inflation expectations push market yields toward 7.5%, that 7% coupon is no longer market-competitive. The bond must trade at a discount to ensure the buyer receives an effective yield that matches the 7.5% market standard. This mechanism ensures that the total return—comprising both interest income and the price appreciation from purchase price to par—equates to the market-required yield.

In your professional recommendations, understanding these dynamics is critical for duration and risk assessment. A bond trading at a steep discount is not necessarily a ‘bargain’ in nominal terms; it reflects the market’s requirement for a higher yield due to interest rate risk or credit profile shifts. By accurately calculating the relationship between the coupon and the yield, you avoid the trap of valuing bonds based on price alone and instead focus on the yield-to-maturity, which serves as the true indicator of value in the Indian debt capital markets.1

Nuance

⚠️ Nuance
Candidates often fall into the trap of assuming that a ‘premium’ bond is inherently higher quality or ‘better’ than a ‘discount’ bond. In reality, the premium or discount is merely a mathematical adjustment to normalize the bond’s yield to current market levels. An analyst must strip away the emotional bias of seeing a price above or below par and focus exclusively on whether the YTM provides sufficient compensation for the credit and duration risk undertaken.

Check Your Understanding

Practice Question 1

A corporate bond with a face value of ₹1,000 and an annual coupon of 8% is currently priced at ₹1,045. Which of the following statements best describes the relationship between the coupon rate and the market yield?

Practice Question 2

If an Indian investor observes that a bond’s price has fallen due to an increase in the prevailing benchmark yield, which of the following is true regarding the bond’s valuation?

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. Yield-to-Maturity (YTM) assumes that all coupon payments are reinvested at the same yield, reflecting the total annualized return if the bond is held to maturity. ↩︎