The U.S. bond market is like baseball – you have to understand and appreciate the rules and strategies, or else it will seem boring. It's also like baseball in that its rules and pricing conventions have evolved and can seem esoteric at times.
The Major League Baseball's official rule book has thousands of words just to cover the rules of what the pitcher can and cannot do.1 In this article, we're going to cover bond market pricing conventions in less than 1,800 words. Bond market classifications are briefly discussed, followed by yield calculations, pricing benchmarks, and pricing spreads.
The Classifications of the Bond Market
There are a great many different kinds of securities and issuers that make up the bond market for investors. It would be possible to fill an entire textbook with a discussion of each individual kind; hence, in order to facilitate a discussion on the functioning of the many bond market pricing conventions, we will be dividing bonds into the following broad categories:
- U.S. Treasuries are bonds that are issued by the Department of Treasury of the United States of America.
- Corporate bonds are bonds that are issued by companies and possess a rating that is considered to be investment-grade.
- High-Yielding Generally referred to as non-investment grade bonds or junk bonds, bonds are defined as those having ratings that are lower than investment grade.
- A bond that is collateralized by the cash flows of principle and interest payments from an underlying pool of single-family residential mortgages is referred to as mortgage-backed securities (MBS).
- The acronym ABS refers to asset-backed securities, which are bonds that are backed by the cash flows of an underlying pool of assets. These assets might include things like auto loans, credit card receivables, home equity loans, airplane leases, and so on. Nearly an infinite number of assets have been converted into ABSs via the process of securitization.
- Debt that is issued by government-sponsored enterprises (GSES), such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, is referred to as agency bonds.
- It is a bond that is issued by a state, city, or municipal government or its agencies. Municipal bonds are often referred to as Munis.One sort of asset-backed instrument is known as a collateralized debt obligation (CDO), which may be backed by any one or multiple other assets. Bonds, loans, ABS, and MBS are all examples.
Estimated rate of return on a bond
When it comes to estimating or determining the anticipated return on a bond, yield is the metric that is used the most commonly. In addition, yield is used as a comparative value metric between different bonds. There are two basic yield measures that need to be understood in order to comprehend the many pricing conventions that are used in the bond market. These yield measures are yield to maturity and spot rates.
When doing a computation for yield-to-maturity, one must first determine the interest rate (discount rate) that will result in the total amount of a bond's cash flows, in addition to the interest that has been accumulated, being equal to the present price of the bond. There are two significant assumptions that are made in this calculation: first, that the bond will be held until maturity, and second, that the cash flows generated by the bond may be reinvested at the yield to maturity in the future.
In order to calculate the spot rate, one must first determine the interest rate (also known as the discount rate) that will result in the present value of a zero-coupon bond being equal to its price. In order to determine the price of a coupon-paying bond, it is necessary to compute a series of spot rates. Each cash flow must be discounted using the proper spot rate, and the price must be equal to the sum of the present values of all of the cash flows. As we will go over in the next section, spot rates are th most common component that is used in the process of comparing the relative values of various kinds of bonds.
Reference Points for Bonds
Bond prices are often determined in relation to a benchmark. At this point, the price of bonds on the market becomes quite complicated. In accordance with the definitions that we presented before, various bond classes make use of distinct price benchmarks.
Prices of on-the-run United States Treasuries, which are the most recent series, are among the most often used benchmarks for pricing. The prices of many bonds are determined in comparison to a particular Treasury bond. It is possible, for instance, that the on-the-run 10-year Treasury may serve as the price benchmark for a 10-year corporate bond offering.
It is common practice to price a bond according to a benchmark curve in situations when the maturity of the bond cannot be determined with absolute certainty due to the presence of call or put features. Specifically, this is due to the fact that the expected maturity of the callable or putable bond most certainly does not correspond precisely with the maturity of a particular Treasury.
The yields of underlying assets with maturities ranging from three months to thirty years are used in the construction of benchmark price curves. The construction of benchmark price curves involves the use of a number of distinct benchmark interest rates or securities options. It is necessary to interpolate yields between the observable yields since there are gaps in the maturities of the securities that are utilized to form a curve to account for these gaps.