Bond Valuation

Use normal NPV analysis using this model:

Spreadsheet_Bond_Valuation.xls

Pricing:

When the U.S. government sells a Treasury bond, they are borrowing money that they pay interest on until the bond comes due - and they pay back the original amount borrowed.  For example: Let's say they sell a bond (which they do in increments of $1,000) for $10,000 that pays interest of 1%, or $100. Once issued however, the bond’s price and yield are based on the demand for bonds and the current interest rate.  If demand is high, buyers may pay more than $10,000 for the bond. Let's say that happens (like it did in mid-December) and the price goes up to $12,000.

The individual who buys this bond is going to receive $100 in interest payments regardless of the price they paid. This means they will earn a lower percentage that the original coupon or yield. Instead of 1%, they will receive .8%.   The reverse is true as well. If interest rates drop, the yield could grow larger than the original yield. These fluctuations occur daily and can be affected by interest rates, demand and equities performance. Think of the yield and the price as sitting on opposite ends of a seesaw. When one goes up the other comes down, and contrary-wise.  If China continues to buy Treasuries, they will increase demand, drive up bond prices and depress treasury yields.

Sensitivity to interest rates:

if rates are expected to fall....then the EXISTING bonds with HIGHER rates will be in high demand...so the price of these bonds will be bid up...

as the price goes up, the "yield to maturity" goes down.

thats why you see headlines like this:  "local currency bond yields fell after economists in a weekly central bank survey said the benchmark interest rate will fall more that previously estimated as economic growth slows."

Links:

• Bond