Treasury bonds are priced based on their yield to maturity and prevailing interest rates. The price of a bond can be at its face value (par value), higher than it, or lower than it.
Understanding Bond Pricing
The pricing of treasury bonds isn't arbitrary; it's closely tied to two key factors:
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Yield to Maturity (YTM): This is the total return an investor can expect to receive if they hold the bond until its maturity date. It considers all coupon payments and the difference between the purchase price and the face value of the bond.
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Prevailing Interest Rates: These are the current rates at which money can be borrowed or lent in the market. They affect the desirability of existing bonds because new bonds are issued at the current interest rate.
The Relationship Between Yield, Interest Rate, and Price
The reference states that the price depends on the yield to maturity and interest rate. Critically, it also highlights that "the yield is higher than the interest rate." This points to an inverse relationship between bond prices and market interest rates. Here's how it works:
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Interest Rates Rise, Bond Prices Fall: When market interest rates increase, newly issued bonds offer a higher yield. Consequently, older bonds paying a lower fixed interest rate become less attractive, and their market prices decrease to reflect the lower return.
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Interest Rates Fall, Bond Prices Rise: Conversely, if interest rates decline, older bonds become more desirable because they pay a higher rate than newly issued ones. This pushes up their market prices.
The Par Value
The price for a bond or a note may be the face value (also called par value). This is the amount the bond will be worth at maturity. However, depending on market conditions, it can trade at either a discount (less than par value) or a premium (more than par value).
Example
Let's say you bought a treasury bond with a face value of $1,000 paying a 3% interest rate, but current interest rates have increased to 4%. The yield to maturity will be higher than the coupon rate. The price of your bond in the open market will likely fall below its $1,000 face value. Conversely, if interest rates fell below 3%, your bond would likely trade at a premium, i.e., above $1,000.
| Factor | Effect on Bond Price |
|---|---|
| Interest Rates Rise | Bond Price Decreases |
| Interest Rates Fall | Bond Price Increases |
| Yield to Maturity | Bond price adjusts to meet YTM rate |
Key Points to Remember
- Bond prices move inversely with interest rates.
- Yield to maturity is the key determinant of bond pricing.
- A bond can be priced at, above, or below its face value.
