25556 Chap.10 Bond Market Segments and Bond Pricing
Bond Market Segments and Bond Pricing
Topic 5 moves from short-term securities to bonds, which pay coupons for years before repaying their face value.
The bond market lets governments, banks and large companies borrow large sums for long periods, gives wholesale investors a defensive asset class, and reveals both default-free long-term rates and the credit spreads that riskier borrowers pay.
This chapter maps the market's segments, from Treasury and semi-government bonds to bank notes, kangaroo bonds, mortgage-backed securities and corporate issues, and explains how Treasury bonds are sold by tender and traded over the counter.
It then prices fixed-coupon bonds on a coupon date at the course's conventions, shows why prices fall as yields rise and why premium and discount bonds arise, and prices a corporate issue whose face value is in millions rather than $100.
What this chapter covers
- 01
Roles of the bond market
- 02
Treasury, semi-government and non-government segments
- 03
Treasury bond tenders and over-the-counter trading
- 04
Bond pricing conventions to assume in the exam
- 05
Premium, par and discount bonds
- 06
Credit ratings and credit spreads
Worked example · free
Measure how much each one-point rise in yield takes off the 6-year 4% bond's price-yield curve
- 1Set up: C/2 = $2 per $100 over 12 half-years, discounted at half the market yield each period.
- 1Prices: 105.454 at 3%, 100.000 at 4%, 94.871 at 5%, 90.046 at 6% and 85.505 at 7%.
- 1Changes: 3% to 4% takes off 5.454; 4% to 5% takes off 5.129; 5% to 6% takes off 4.825; 6% to 7% takes off 4.541.
- 1Pattern: every rise lowers the price, but each extra point removes less than the one before, so the curve flattens as yields climb.
Key terms
- Coupon
- A fixed interest payment on a bond, paid twice a year on Australian Treasury bonds and set by the coupon rate times the face value.
- Credit spread
- The extra yield a borrower pays above the default-free Treasury yield because of its credit risk.
- Kangaroo bond
- An Australian dollar bond sold in Australia by a highly rated issuer based overseas.
- Semi-government bond
- A bond issued by a state borrowing authority on behalf of a state or territory government or its agencies.
- Credit rating
- An agency's assessment, paid for by the issuer, of how likely a security is to be repaid in full and on time.
Bond Market Segments and Bond Pricing FAQ
Why do bond prices fall when market yields rise?
A bond's coupons and face value are fixed, so its price is their present value at the current yield. Discounting the same payments at a higher rate gives a smaller present value, so the price falls; a lower yield does the opposite.
When does a bond trade at a premium or a discount?
If the coupon rate is above the market yield, investors pay more than face value, a premium. A coupon rate below the market yield produces a price under face value, a discount. When the two are equal, the price is exactly 100 per $100.
What pricing conventions should I assume for bond questions?
Unless told otherwise, use a semi-annual compound yield, coupons paid every six months, prices per $100 of face value rounded to three decimals, and settlement two business days after the trade. The Topic 5 workshop says to assume these in the exam.
How do I price a bond whose face value is not $100?
Use the same formula with the actual face value. The half-yearly coupon becomes the coupon rate times the face value divided by two, and the face value term uses the full amount. The tutorial flags this as a common exam mistake.
Why does the government issue bonds when it does not need to borrow?
A liquid Treasury market reveals default-free long-term interest rates, which every other borrower and investor uses as a reference. Keeping that market active benefits the whole financial system, so issuance continues even in years without a funding need, and the three-year and ten-year yields serve as the benchmarks.
Exam move
Learn the bond price formula by writing it out with the conventions attached: half the coupon, half the yield, twice the years. Price one bond at three yields, below, at and above its coupon, until you can predict premium, par or discount before calculating. Then repeat one question with a face value in millions to avoid the mistake the tutorial highlights.
For the descriptive side, keep a six-row table of segments with issuer, selling method and one distinguishing feature, and practise classifying unfamiliar issuers into it. Finish with one paragraph explaining what a credit spread is and why spreads widened during the GFC.
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