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Getting to grips with the pricing of corporate bonds

by , 28 May 2014

When listed companies, or corporations, decide to sell debt to investors, they use an instrument called a corporate bond. They work in a similar way to government bonds. The company pays you so much in interest every year. Then once the term of the bond is up, pays you back what you paid in the first place. But corporate bonds usually change hands until they mature. So what effects the price? Let's take a closer look…

What is a corporate bond’s par value?

When a company decides on selling corporate bonds, it gives the bond a par value. This is the starting value.

Let’s say that a corporate bond’s par value is R1,000. If the price of the corporate bond rises above that, it’s said to be trading above par. And if the price of the corporate bond falls below that, it’s said to be trading below par.

Bond prices move around, Phil Oakley in Money Week explains. So when you buy bonds, you need to understand how the pricing works so that you don’t overpay for it.

Let’s have a look at an example of how the pricing works…

It’s 1 January and a new 6% bond begins trading at R1,000. With a 6% interest rate (coupon), it pays R60 a year. The company pays this out twice a year at payments of R30 at the end of June and December.

The difference between the clean price and the dirty price

At the end of March, you decide that you want to buy this bond. You pay R1,015 for the bond. So why is the price more expensive?

Well it comes down to the accrued interest. When you buy bonds between interest (coupon) payment dates, the seller can charge for the interest covering the period he’s missing out on.

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So in this case, the extra R15 is to cover three months of interest (R60/12 x 3).

Now, your broker’s website may list the price as R1,000. This is the clean price. But you pay more at R1,050. This is the dirty price. And the dirty price includes the accrued interest.

So there you have it, getting to grips with the pricing of corporate bonds.

Getting to grips with the pricing of corporate bonds
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