How Is the Price of a Specific Bond Determined?
Par Value
Bonds are priced by supply and demand forces, either at auction or on an open market. There are, however, specific factors that influence what investors are willing to pay for bonds, and, of course, the price that's paid for a bond ultimately determines its yield.
Par value is simply the face value of the bond, the amount that is paid at maturity. For Treasuries, par value is usually $10,000, though for other bonds par value can vary widely. A bond will often trade at a discount to, that is less than, the par value, simply to compensate the investor for the time and risk of holding the bond. If interest rates decline, however, investors may seek to bid up the price of the bond while it offers a higher return, possibly causing the bond to trade at a premium to par, meaning greater than the face value.
Valuing a Bond
The true value of a bond over time, of course, is more than just the face value amount paid at maturity. In most cases, a bond entitles the holder to receive regularly scheduled interest payments called coupons. The total value of a bond is, therefore, the par value plus the coupon payments. Because the coupon payments can also be reinvested, the potential value of the bond can be even higher still.
What makes pricing a bond somewhat speculative is that its value can only be realized at some point in the future, which introduces potential credit and interest rate risk. The higher the price that is paid for the bond, the lower the overall percentage yield can be obtained by holding it to maturity. Depending on the prevailing interest rates for bonds of similar creditworthiness and maturity, and for the general economic climate, investors will bid in an attempt to obtain the bond for the lowest price and highest yield possible.
Other Strategies
However, not all bond investors seek to hold bonds to maturity. Some merely use bonds of various maturities to speculate on future interest rates. As mentioned, if rates move lower, the price investors are willing to pay for a bond increases. Conversely, if interest rates are expected to move higher, investors may sell bonds. Another common technique is to buy bonds of short maturity - anything from a few days or weeks to two years - and loan the coupon payments at longer maturity where the return rate is higher. This is called playing the yield curve, because the yield for bonds tends to slope positively as the distance to maturity increases. The yield curve is not always positively sloped, however, particularly in times of restrictive monetary policy where short term rates are rising and inflation is considered negligible.
