Market value of a bond

A bond's face value is a number fixed at issue and printed on the certificate — the principal the issuer promises to repay at maturity. What it actually sells for on any given day before maturity is a different number entirely: its market value.

The two can diverge a great deal, and the direction and size of that gap is one of the most heavily tested ideas in the whole debt chapter.

The workbook's definition is direct: if a debt instrument is traded in the market before its maturity, the price at which that trade is executed is its market value — and market value may be higher or lower than face value.

What moves it is named explicitly too: demand-supply conditions and the market interest rate scenario. A bond's coupon was fixed when it was issued; if market interest rates move after that, the bond's price has to move to compensate a new buyer, because the coupon itself cannot change.

The workbook also distinguishes market value from yield: the return an investor actually earns on a bond is not the coupon rate but the yield — the coupon relative to the price actually paid. Current yield is the simplest version of this: coupon divided by market price. A bond paying an annual coupon of 12 percent trading at Rs 109.50 has a current yield of 12 ÷ 109.50 = 10.95 percent — lower than the coupon, because the market price sits above face value.

A company issued a bond at face value Rs 100, coupon 8 percent, three years ago. Interest rates in the market have since fallen.

Because new bonds now offer only, say, 6 percent, this older 8 percent bond is more attractive at its old coupon — so buyers bid its price up. It now trades at Rs 109.50 in the market: the market value, well above its unchanged face value of Rs 100.

An investor who buys it today at Rs 109.50 still receives the same Rs 8 a year in coupon — 8 percent of the Rs 100 face value, not of the Rs 109.50 he paid. His current yield is therefore:

Current yield = 8 ÷ 109.50 = 7.31 percent

lower than the 8 percent coupon printed on the certificate, because he paid more than face value to get it. Had interest rates instead risen since issue, the same bond would trade below Rs 100, and a buyer's current yield would work out above 8 percent — the price is what adjusts to make an old fixed coupon competitive with new market rates.

Chapter 3 (Characteristics of Debt Securities), section 3.2, defines market value directly after face value, and section 3.3 immediately builds current yield and yield to maturity on top of it. Expect a question distinguishing face value from market value, and a numerical question computing current yield from a coupon and a market price.

• Face value is fixed; market value moves with demand-supply and interest rates. They are only equal by coincidence, or at issue and maturity in a plain vanilla bond.
• The coupon rate is computed on face value, always — a bond's Rs 8 coupon stays Rs 8 a year regardless of what an investor paid for it.
• Current yield uses market price in the denominator, not face value — this is exactly what makes it diverge from the coupon rate.
• Coupon rate is not a measure of an investor's actual return once the bond trades away from par — yield is.