Bond pricing and yields

A bond is a loan in tradeable form. The borrower (issuer) promises to pay fixed interest (coupon) periodically and return the principal (face value) at maturity. The price at which this bond trades in the secondary market depends on how the current interest rate environment compares to the coupon and how risky the issuer is.

The critical relationship: bond price and yield move in opposite directions. If market interest rates rise after you buy a bond, your bond pays a lower coupon relative to new bonds, so its price falls to compensate. If rates fall, your bond looks attractive, its price rises.

This inverse relationship is the central mechanic of fixed income investing. Understanding it explains why RBI rate hikes cause bond prices to fall, and rate cuts cause them to rally, even though nothing changed about the bond's coupon payments.

Bond Pricing Formula:

P = Σ [C ÷ (1+y)^t] + [FV ÷ (1+y)^n]

Where: C = coupon payment, y = yield to maturity (YTM), n = number of periods, FV = face value

Example: 3-year bond, face value ₹1,000, coupon 8% (paid annually), YTM 10%: P = 80/(1.10) + 80/(1.10)² + 1,080/(1.10)³ = 72.7 + 66.1 + 811.0 = ₹949.8 (below par, discount bond)

Key yield measures:

• Coupon Rate: Fixed contractual rate on face value
• Current Yield = Annual Coupon ÷ Market Price (ignores capital gain/loss to maturity)
• YTM: The single discount rate that equates PV of all future cash flows to market price, the most complete return measure
• Yield Spread: YTM minus the G-sec yield of similar maturity, represents the credit risk premium

Par, premium, and discount:

• YTM = Coupon Rate → Price = Par
• YTM > Coupon Rate → Price < Par (discount bond)
• YTM < Coupon Rate → Price > Par (premium bond)