Question

How to determine the price for a floating bond issue?

Answer 1

The bond market consists of a great number of issuers and types of securities. To talk about each specific type might fill an entire textbook; therefore, for the purposes of discussing how various bond market pricing conventions work, we make the following major bond classifications:

• U.S. Treasuries: bonds issued by the United States Department of the Treasury.
• Corporate Bonds: bonds issued by corporations that carry an investment-grade rating
• Mortgage-Backed Securities (MBS): a bond collateralized by the cash flows of principal and interest payments from an underlying pool of single-family residential mortgages.
• Asset-Backed Securities (ABS): a bond collateralized by the cash flows of an underlying pool of assets such as auto loans, credit card receivables, home equity loans, aircraft leases, etc. The list of assets that have been securitized into ABSs is almost endless.
• Agency Bonds: debt issued by the government-sponsored enterprises (GSEs), including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.
• Municipal Bonds: a bond issued by a state, city or local government or its agencies.

A Bond's Expected Return:

• Yield is the measure used most frequently to estimate or determine a bond's expected return. Yield is also used as a relative value measure between bonds. There are two primary yield measures that must be understood to understand how different bond market pricing conventions work:

1. yield to maturity and
2. spot rates.

• A yield-to-maturity calculation is made by determining the interest rate (discount rate) that will make the sum of a bond's cash flows, plus accrued interest, equal to the current price of the bond. This calculation has two important assumptions: first, that the bond will be held until maturity, and second, that the bond's cash flows can be reinvested at the yield to maturity.
• As we discuss below, spot rates are most often used as a building block in relative value comparisons for certain types of bonds.

Benchmarks for Bonds:

• Most bonds are priced relative to a benchmark. This is where bond market pricing gets a little tricky. Different bond classifications, as we have defined them above, use different pricing benchmarks.
• When the maturity of a bond cannot be known with exactness because of call or put features, the bond is frequently priced to a benchmark curve. This is because the estimated maturity of the callable or put-able bond most likely does not coincide exactly with the maturity of a specific Treasury.

Yield Spreads for Bonds:

• A bond's yield relative to the yield of its benchmark is called a spread. The spread is used both as a pricing mechanism and as a relative value comparison between bonds.

Types of Bonds and Their Benchmark Spread Calculation:

1. High-Yield Bonds - High-yield bonds are usually priced at a nominal yield spread to a specific on-the-run U.S. Treasury bond. However, sometimes when the credit rating and outlook of a high-yield bond deteriorates, the bond will start to trade at an actual dollar price.
2. Corporate Bonds - A corporate bond is usually priced at a nominal yield spread to a specific on-the-run U.S. Treasury bond that matches its maturity.
3. Asset-Backed Securities (ABS) - ABS frequently trade at a nominal yield spread at their weighted average life to the swap curve.
4. Agencies - Agencies frequently trade at a nominal yield spread to a specific Treasury, such as the on-the-run 10-year Treasury. Callable agencies are sometimes evaluated based on an OAS where the spot rate curve(s) are derived from the yields on non-callable agencies.

Summary:

• Bond market pricing conventions are a little bit tricky, but understanding the basics removes some of the ambiguity and may even make it enjoyable. Bond pricing is really just a matter of identifying a pricing benchmark, determining a spread and understanding the difference between two basic yield calculations: yield to maturity and spot rates. With that knowledge, understanding how various types of bonds are priced shouldn't be intimidating.
• Bond prices are intrinsically linked to the interest rate environment in which they trade - with prices falling as interest rates rise
• Bond prices are also greatly influenced by the creditworthiness of the issuer, from the federal government down to a junk bond issuer on the verge of default.
• Bond prices and yields can be calculated in several different ways, depending on the type of bond and the definition of yield you're using.
• Benchmarks exist to track bond yields and serve as a relative measure of price performance.