Fixed Income - Pricing Factors

Pricing Factors

The main number which is used to assess the value of the bond is the gross redemption yield. This is defined such that if all future interest and principal repayments are discounted back to the present, at an interest rate equal to the gross redemption yield (gross means pre-tax), then the discounted value is equal to the current market price of the bond (or the initial issue price if the bond is just being launched). Fixed income investments such as bonds and loans are generally priced as a credit spread above a low-risk reference rate, such as LIBOR or U.S. or German Government Bonds of the same duration. For example, if a 30 year mortgage denominated in US dollars has a gross redemption yield of 5% per annum and 30 year US Treasury Bonds have a gross redemption yield of 3% per annum (referred to as the risk free yield), the credit spread is 2% per annum (sometimes quoted as 200 basis points). The credit spread reflects the risk of default. Risk free interest rates are determined by market forces and vary over time, based on a variety of factors, such as current short-term interest rates, e.g. base rates set by central banks such as the US Federal Reserve, the Bank of England in the UK, and the Euro Zone ECB. If the coupon on the bond is lower than the yield, then its price will be below the par value, and vice versa.

In buying a bond, one is buying a set of cash flows, which are discounted according to the buyer's perception of how interest and exchange rates will move over its life.

Supply and demand affect prices, especially in the case of market participants who are constrained in the investments they make. Insurance companies and pension funds usually have long term liabilities that they wish to hedge, which requires low risk, predictable cash flows, such as long dated government bonds.