Question

Explain: bond prices settle at the level people are willing to hold them.

Graph this.

Answer 1

Bond prices are determined by 5 factors:

1. par value
2. coupon rate
3. prevailing interest rates
4. accrued interest
5. credit rating of the issuer

Generally, the issuer sets the price and the yield of the bond so that it will sell enough bonds to supply the amount that it desires. The higher the credit rating of the issuer, the lower the yield that it must offer to sell its bonds. A change in the credit rating of the issuer will affect the price of its bonds in the secondary market: a higher credit rating will increase the price, while a lower rating will decrease the price. The other factors that determine the price of a bond have a more complex interaction.

When a bond is first issued, it is generally sold at par, which is the face value of the bond. Most corporate bonds, for instance, have a face and par value of $1,000. The par value is the principal, which is received at the end of the bond's term, i.e., at maturity. Sometimes when the demand is higher or lower than an issuer expected, the bonds might sell higher or lower than par. In the secondary market, bond prices are almost always different from par, because interest rates change continuously. When a bond trades for more than par, then it is selling at a premium, which will pay a lower yield than its stated coupon rate, and when it is selling for less, it is selling at a discount, paying a higher yield than its coupon rate. When interest rates rise, bond prices decline, and vice versa. Bond prices will also include accrued interest, which is the interest earned between coupon payment dates. Clean bond prices are prices without accrued interest; dirty bond prices include accrued interest.

Most stocks and bonds settle within two business days after the transaction date. This two-day window is called the T+2. Government bills, bonds, and options settle the next business day. Spot foreign exchange transactions usually settle two business days after the execution date.