Five Things You Must Know About Bond Pricing

If interest rates were the same for all borrowers, as a lender, you would still be more likely to lend money to the Omnipotent Borrower rather than the Deadbeat. So in order to entice lenders to extend credit to the Deadbeats, these higher-risk borrowers have to agree to pay lenders a higher rate of interest than the Omnipotent Borrowers have to pay.

Thus, to differentiate the riskiness of borrowers, the markets have established a rating system. Bond issuers are evaluated for their ability to repay based upon a review process. The most influential rating agencies are Moody's , Standard & Poor's and Fitch.

These agencies will express their ratings in some sort of gradation, with the highest credit rating assigned to the U.S. Government. After the U.S. Government, the highest credits are then typically assigned an AAA rating, followed by AA, A, BBB, BB, B, CCC and so on. Some rating agencies also add a plus (+) or minus (-) designation.

With the ratings in hand, the markets will then be able to ascertain the rates of interest that all borrowers will be required to pay. U.S. Government bonds, being the least risky and most liquid debt securities, are the base (see benchmark ) on which other rates are established (see "Bond Ratings").

A credit "spread" is then established by the marketplace. This spread represents the difference in interest rates between U.S. Government securities and other debt instruments that are identical in all respects except for credit rating (see yield spread ).

4. Yield Curve

While one facet of bond risk is the credit rating, there is another element of risk to consider, the dimension of time. Holding credit ratings constant, the interest rate demanded by lenders will vary according to time to maturity. The relationship between time and interest rates is referred to as the yield curve .

Normally, as time increases, the yield on bonds will increase. This is referred to as a normal yield curve. On some occasions, yields will be less for longer maturities than short maturities. This is referred to as an inverted yield curve. Inverted yield curves are the result of supply-demand conditions or, in some investors' opinions, an inverted yield curve is a signal of an impending financial crisis or imminent recession .