The market determines the stock exchange price of a publicly traded stock, but that is not the case for bonds. With the current trend of buying short-term bonds, it is likely that you will need to buy some. We need to look at the OTC (over the counter) market to purchase them. Their might be a only a few sellers and they might be low balling you. How can you check if the price they are offering is even remotely acceptable?

Let’s look at the details of the bond with the following example:

A fixed rate bond maturing in 2 years has a 5% coupon. The redemption will be at 101% and the 2-year yield to maturity rate is 4,25%. What is the price?

Luckily, their is a formula we can use to compute the answer. As usual, we will discount the cash flow by adding the 1st year return with the second year return and adding the final redemption. In other words, we have three elements:

P = 1st year return + 2nd year return + redemption value

P= 5/(1,0425) + 5/(1,0425)^2 + 101/(1,0425)^2 = 102,33%

Is the above tool (calculation method) really reliable?

When picking bonds, you also have to bear in mind the risks (interest, yield curve, reinvestment, credit, liquidity and volatility risk). If you blindly look at the above numbers, you are likely to buy an illiquid junk bond issued by a dubious government or company. In other words, the discount you get in the price might be translating to an unnecessarily high risk premium.