How to price treasury bonds

The market for treasury bonds has cheap bonds, fairly priced bonds, and expensive bonds. Cheap bonds are bought at a discount to face value. Fairly priced bonds are bought at par, and expensive bonds are bought at a premium. Before I lose you, let me first explain what treasury bonds are.

Governments all over the world spend more money than they earn. Economists call this an expansionary fiscal policy. Politicians tend to spend money today to please voters and then leave the mess they create for future generations to sort out. Most governments raise money from taxation but this is not sufficient to cover the budget. So they resort to borrowing by issuing treasury bills and bonds. A treasury bill or bond is simply a promise from a government to pay you back your principal plus interest over a certain period of time. When you lend to the government for less than a year we call it a treasury bill. Treasury bonds have maturity periods exceeding one year.

These promises are exchangeable in the bond market. I can sell my promise to someone else. I can sell my bond or promise at a discount, at par, or at a premium. Let me explain.

But first, let me take you back to some high school economics. In a free market, the price of a commodity is the point at which the supply curve meets the demand curve. This equilibrium point is the point at which supply meets demand. When supply exceeds demand, prices tend to fall, and when demand outstrips supply, prices go up. The same thing applies to bonds. 

When the Bank of Uganda auctions a bond, it is usually issued at par. This means that the price of the bond is the same as the face value. The face value is what you get back at the end of the maturity period. After the auction, the bond prices are determined by the free market. The price of a bond is inversely related to the prevailing interest rates which are in turn directly correlated with the inflation rate. When inflation goes up, the central bank increases interest rates. This makes new bond issues more attractive which increases demand for new issues but reduces demand for existing bonds. This decreases the prices of existing bonds. The reverse is true. When interest rates go down because of low inflation, new issues are less attractive which increases demand for old issues which pushes prices up. 

Bond prices are also affected by other factors like the remaining time to maturity and the timing of coupons. 

There is a difference between the coupon rate and the yield to maturity. When bonds are priced at par it means that the coupon is the same as the yield. When the yield exceeds the coupon, the bond is trading at a discount. When the coupon exceeds the yield, the bond is at a premium. The coupon is the quoted interest rate on a particular bond. The yield is the overall return that the bond is expected to pay over its lifetime.

Now how does this concern you? Well, when you decide to join the bond market you need to know these things. Ideally, you are looking for cheap bonds with a high coupon and high yield. If you choose to buy premium bonds, ensure that the coupon is reasonably high to compensate you for the additional cost. The bonds you buy should have a reasonable time left to maturity so you can get more interest income. You can also consider building a so-called bond ladder which is made up of bonds of different maturities and yields. Such a bond ladder can provide you with passive income for years to come.

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