One of a bond’s basic attributes is its par value, which (roughly) corresponds to the initial funds received by the issuer. In the most idealized bond with neither call features nor sinking funds, the final “principal payment” at maturity will also be generally equal to this par value. The par value is typically set at $1,000, with the bond’s price and coupon payment then expressed as a percentage of this $1,000 standard. Thus, for a coupon rate that coincides with our fixed market discount rate of 8%, the PV of $1,000 would just match the par value, the price ratio would just be 100% and the bond would be called—not surprisingly—a “par bond.”
For coupon rates higher than the discount rate (generally, for bonds that had been issued earlier during a higher rate environment), the PV would exceed the par value, so the price ratio would be greater than 100%, and such a bond would be called a “premium bond.” Similarly, lower coupon rates and lower PVs would give rise to price ratios below 100%—hence, “discount bonds.”
Now, all this is pretty old hat. Why go through this entire discussion of a flat discount world only to come to these standard descriptions of the three bond types? The point is that these characterizations are really somewhat misleading. All these bonds are fairly priced in the sense that their PV corresponds to their market price. A “discount bond” is not a bargain, nor is a “premium bond” really worth more than a par bond. Only when some differentiating features are incorporated into the analysis does any investment look cheap or dear to a specific investor.
To really understand the YTM, our flat-world assumption must be replaced by the more realistic situation where bond prices are based on a host of differentiating factors such as credit quality, maturity, coupon level, sinking funds, call features, market liquidity, and so forth. In this environment, one can argue about whether the bond’s price or the YTM is the primary determinant of value. The basic fact is that a bond’s price, and its YTM, are defined in a circular fashion.7 Thus, for any given bond, the YTM is the specific discount rate that generates a PV equal to the bond’s market price. Different pricing effects can then also be expressed as different YTMs. Over the years, this YTM approach has proven to be a very convenient comparative yardstick. For example, it has now become commonplace to characterize the incremental return of corporate bonds in terms of their YTM “spread” over the U.S. Treasury bond curve.
Read More : Bond Prices and Yields
