APPENDIX B Bond Pricing

Return on Debt Securities

The yield on a debt security represents the return on the investor's investment. By yield, we mean the interest rate that can be earned on the bond, as currently quoted by the market or implied by the current market price.

The yield is not the same as the coupon paid by the issuer, which is based on the coupon rate and the face value of a bond. For example, a corporate bond with a par value of $1,000 may promise to pay a coupon rate of 5% annually for ten years, which comes to $50 a year. But if doubts arise about the issuer's ability to repay, nervous investors may sell the bond at a discount, say for only $900, for fear they will get nothing if the issuer defaults.1

If the issuer does default, then the bondholder will not earn any yield at all and could be forced to accept a steep discount on the $1,000 par value or lose the principal altogether. There could be a zero return on debt securities and even a wipe-out of the investment.

This example also illustrates the price-yield relationship in bonds. When a bond's price goes up, its yield goes down. When its price falls, its yield goes up. There will be buyers for the bond in either direction because, as discussed earlier, the various bond market players have different needs and purposes. Proprietary traders are primarily interested in price because their interest is to make money as soon as possible; long-term investors are mainly focused on yield because they have a long ...

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