How bond market pricing works

The US bond market is like a baseball. You must understand and appreciate the rules and strategies, otherwise it will appear boring. It is also like baseball, and its rules and pricing practices have evolved and sometimes seem esoteric.

In the “Major League Baseball Official Rulebook”, the rules covering what pitchers can and cannot do require more than 3,600 words. In this article, we will introduce bond market pricing practices in less than 1,800 words. The bond market classification was briefly discussed, followed by yield calculation, pricing benchmarks, and pricing spreads.

The basic knowledge of these pricing conventions will make the bond market look as exciting as the best world series of baseball games.

Key points

  • Bond prices are inherently related to the interest rate environment in which they are traded-prices fall as interest rates rise.
  • Bond prices are also greatly affected by the creditworthiness of issuers, from the federal government to junk bond issuers on the brink of default.
  • Bond prices and yields can be calculated in several different ways, depending on the type of bond and the yield definition you use.
  • Benchmarks exist to track bond yields and serve as a relative measure of price performance.

Bond market classification

The bond market is composed of a large number of issuers and types of securities. Talking about each specific type may fill up an entire textbook; therefore, in order to discuss how various bond market pricing practices work, we have classified bonds as follows:

  • U.S. Treasury Bonds: Bonds issued by the U.S. Treasury Department
  • Corporate bonds: bonds issued by companies with investment grade ratings
  • High-yield bonds: bonds that are rated lower than investment-grade—also called non-investment-grade bonds or junk bonds
  • Mortgage-Backed Securities (MBS): A bond that uses the cash flow of principal and interest payments from the basic pool of single-family residential mortgage loans as collateral
  • Asset-backed securities (ABS): Bonds collateralized by the cash flow of basic asset pools such as auto loans, credit card receivables, home equity loans, and aircraft leasing. The list of assets that have been securitized into asset-backed securities is almost endless.
  • Institutional bonds: bonds issued by government-sponsored companies (GSE), including Fannie Mae, Freddie Mac, and the Federal Housing Loan Bank
  • Municipal Bonds (Munis): Bonds issued by state, city, or local governments or their agencies
  • Collat​​eralized Debt Obligations (CDO): ​​An asset-backed security backed by any one or more other ABS, MBS, bonds or loans

How bond market pricing works

Expected return on bonds

Yield is the most commonly used measure to estimate or determine the expected return of a bond. Yield is also used as a measure of the relative value of bonds. To understand how different bond market pricing practices work, it is necessary to understand two main yield indicators: yield to maturity and spot yield.

Yield to maturity is calculated by determining the interest rate (discount rate) that makes the bond’s cash flow plus accrued interest equal to the bond’s current price. This calculation has two important assumptions: First, the bond will be held to maturity, and second, the cash flow of the bond can be reinvested at the yield to maturity.

The spot interest rate is calculated by determining the interest rate (the discount rate) that makes the present value of the zero coupon bond equal to its price. A series of spot interest rates must be calculated to price the bonds that pay the coupons—each cash flow must be discounted using the appropriate spot interest rate so that the sum of the present value of each cash flow equals the price.

As we discuss below, spot interest rates are most often used as the basis for comparing the relative value of certain types of bonds.

Bond benchmark

Most bonds are priced relative to benchmarks. This is where the bond market pricing becomes a bit tricky. As we defined above, different bond classifications use different pricing benchmarks.

Some of the most common pricing benchmarks are U.S. Treasury bonds in action (the latest series). Many bonds are priced relative to specific Treasury bonds. For example, a 10-year treasury bond in operation may be used as a pricing benchmark for 10-year corporate bond issuance.

When the maturity date of the bond cannot be accurately known due to the bullish or bearish characteristics, the bond is usually priced according to the benchmark curve. This is because the estimated maturity date of a redeemable or sellable bond is likely not exactly the same as the maturity date of a particular Treasury bond.

The benchmark pricing curve is constructed from the yield of the underlying securities with a useful life of 3 months to 30 years. Use several different benchmark interest rates or securities to construct a benchmark pricing curve. Because of the gap in the maturity of the securities used to construct the curve, the yield must be inserted between the observable yields.

For example, one of the most commonly used benchmark curves is the running U.S. Treasury curve, which is constructed using recently issued U.S. Treasury bonds, notes, and notes. Since securities are only issued by the U.S. Department of the Treasury and have maturities of three months, six months, two years, three years, five years, ten years, and 30 years, the yield of theoretical bonds with maturity between the two The due date must be inserted. This treasury bond curve is called the interpolated yield curve (or I curve) by bond market participants.

Other popular bond benchmark pricing curves

  • Spot Treasury Bond Interest Rate Curve: A curve constructed using the theoretical spot interest rate of U.S. Treasury bonds
  • Swap Curve: A curve constructed using the fixed interest rate side of interest rate swaps
  • Eurodollar curve: A curve constructed using interest rates derived from the pricing of Eurodollar futures.
  • Agency curve: a curve constructed using the yield of non-redeemable fixed-rate agency debt

Bond yield differential

The yield of a bond relative to its benchmark yield is called the spread. The spread is used both as a pricing mechanism and as a relative value comparison between bonds. For example, a trader might say that the trading spread of a corporate bond is 75 basis points higher than that of a 10-year Treasury bond. This means that the yield to maturity of the bond is 0.75% higher than the yield to maturity of the 10-year treasury bond in operation.

It is worth noting that if different corporate bonds with the same credit rating, prospect and duration are traded at a spread of 90 basis points on the basis of relative value, the second bond will be a better choice.

Different pricing benchmarks use different types of spread calculations. The four main yield differential calculations are:

  1. Nominal yield difference: the difference between the bond’s yield to maturity and its benchmark yield to maturity
  2. Zero volatility spread (Z-spread): When added to the yield of each point on the spot interest rate Treasury bond curve (where the bond cash flow is received), the price of the security will be equal to the constant spread of the current price and its cash Flow value
  3. Option Adjusted Spread (OAS): OAS is used to evaluate bonds with embedded options (such as callable bonds or sellable bonds). The fixed spread, when added to the yield of each point on the bond cash flow spot interest rate curve (usually the U.S. Treasury spot interest rate curve), will make the bond price equal to its cash flow. However, to calculate the Organization of American States, the spot interest rate curve has multiple interest rate paths. In other words, many different spot interest rate curves are calculated and the different interest rate paths are averaged. The Organization of American States considered interest rate fluctuations and the possibility of repaying the bond principal early.
  4. Discount Margin (DM): Variable rate bonds are usually priced close to their face value. This is because the interest rate (coupon) of a floating-rate bond will be adjusted to the current interest rate based on changes in the bond’s reference interest rate. DM is the interest rate difference. When added to the current reference interest rate of the bond, it will make the cash flow of the bond equal to its current price.

Bond type and its benchmark spread calculation

High yield bond

High-yield bonds are usually priced at the nominal yield spread of a particular U.S. Treasury bond in operation. However, sometimes when the credit rating and outlook of a high-yield bond deteriorates, the bond will begin to trade at real U.S. dollar prices. For example, the transaction price of this type of bond is $75.875, while the transaction price of the 10-year Treasury bond is 500 basis points.

Corporate bonds

Corporate bonds are usually priced at nominal yield spreads that match specific current U.S. Treasury bonds with their maturity dates. For example, 10-year corporate bonds are priced based on 10-year treasury bonds.

Mortgage-backed securities (MBS)

There are many different types of MBS. Many of them trade with the I-curve of U.S. Treasury bonds at their nominal rate of return on their weighted average lifespan. Some adjustable-rate MBS are traded with DM, and others are traded with Z spreads. Some CMOs trade to specific Treasury Departments at nominal yield spreads. For example, a 10-year planned amortization bond may be traded at a nominal yield spread with a running 10-year treasury bond, or a Z bond may be traded at a nominal yield spread with a running 30-year treasury. Because MBS embeds a call option (borrowers can choose to repay the mortgage in advance for free), OAS is often used to evaluate it.

Asset-backed securities (ABS)

ABS often trades at the nominal rate of return spread between its weighted average life and the swap curve.


Institutions often use nominal yield spreads to trade with specific Treasury bonds, such as 10-year Treasury bonds in operation. Sometimes redeemable institutions are evaluated based on OAS, where the spot interest rate curve is derived from the yield of non-redeemable institutions.

Municipal bonds

Due to the tax advantages of municipal bonds (usually not taxed), the correlation between their yields and U.S. Treasury yields is not as good as that of other bonds. As a result, municipal bonds are often traded at full yield to maturity or even dollar prices. However, the ratio of the yield of the municipality to the yield of the benchmark Treasury bond is sometimes used as a measure of relative value.

Mortgage Debt Obligation (CDO)

Like MBS and ABS, which often support CDOs, there are many different pricing benchmarks and yield measures used to price CDOs. The Eurodollar curve is sometimes used as a benchmark. The discount margin is used for floating interest rates. OAS calculations are used for relative value analysis.

Bottom line

Bond market pricing conventions are a bit tricky, but like baseball rules, understanding the basics can dispel some ambiguities and may even make it interesting. Bond pricing is actually just to determine the pricing benchmark, determine the spread and understand the difference between the two basic yield calculations: yield to maturity and spot yield. With this knowledge, understanding how various types of bonds are priced shouldn’t be daunting.


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