Table of Contents Expand Table of Contents Bond Market Classifications A Bond's Expected Return Benchmarks for Bonds Yield Spreads for Bonds Types of Bonds The Bottom Line How Bond Market Pricing Works By Barry Nielsen Full Bio Barry Nielsen is the owner and operator of MortgageGraphics Inc. He has 20 years of experience in the mortgage and lending business. Learn about our editorial policies Updated July 19, 2023 Reviewed by Julius Mansa Part of the Series Guide to Fixed Income Guide to Fixed Income: Types and How to Invest Introduction to Fixed Income The Basics Of Bonds Fixed-Income Security What Is a Fixed-Rate Bond? Interest Rates, Inflation, And Bonds Types of Fixed Income Government Bond Treasury Bond (T-Bond) Bonds vs. Notes vs. Bills Treasury Inflation-Protected Securities (TIPS) Municipal Bond Corporate Bond Convertible Bond High-Yield Bond Junk Bond Callable Bond Understanding Fixed Income Bond Market vs. Stock Market Equity Market vs. Fixed-Income Market Cash vs. Bonds Money Market vs. Short-Term Bonds The Secondary Market: "Over the Counter" Zero-coupon Bond vs. a Regular Bond Fixed Income Investing How Bond Market Pricing Works CURRENT ARTICLE Creating a Modern Fixed-Income Portfolio Whereto Buy Government Bonds Treasury Bonds and Retirement Risks and Considerations 7 Common Bond-Buying Mistakes Interest Rate Risk Pros and Cons of Inflation-Linked Bonds The U.S. bond market is like baseball – you have to understand and appreciate the rules and strategies, or else it will seem boring. It's also like baseball in that its rules and pricing conventions have evolved and can seem esoteric at times. The Major League Baseball's official rule book has thousands of words just to cover the rules of what the pitcher can and cannot do. In this article, we're going to cover bond market pricing conventions in less than 1,800 words. Bond market classifications are briefly discussed, followed by yield calculations, pricing benchmarks, and pricing spreads. Basic knowledge of these bond pricing conventions will make the bond market seem as exciting as the best World Series baseball game. Key Takeaways Bond prices are intrinsically linked to the interest rate environment in which they trade - with prices falling as interest rates rise.Bond prices are also greatly influenced by the creditworthiness of the issuer, from the federal government down to a junk bond issuer on the verge of default.Bond prices and yields can be calculated in several different ways, depending on the type of bond and the definition of yield you're using.Benchmarks exist to track bond yields and serve as a relative measure of price performance. Bond Market Classifications The bond market consists of a great number of issuers and types of securities. To talk about each specific type might fill an entire textbook; therefore, for the purposes of discussing how various bond market pricing conventions work, we make the following major bond classifications: U.S. Treasuries: bonds issued by the United States Department of the Treasury Corporate Bonds: bonds issued by corporations that carry an investment-grade rating High-Yield Bonds: bonds with ratings below investment grade – also known as non-investment grade bonds or junk bonds Mortgage-Backed Securities (MBS): a bond collateralized by the cash flows of principal and interest payments from an underlying pool of single-family residential mortgages Asset-Backed Securities (ABS): a bond collateralized by the cash flows of an underlying pool of assets such as auto loans, credit card receivables, home equity loans, aircraft leases, etc. The list of assets that have been securitized into ABSs is almost endless. Agency Bonds: debt issued by the government-sponsored enterprises (GSES), including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks Municipal Bonds (Munis): a bond issued by a state, city or local government or its agencies Collateralized Debt Obligations (CDOs): a type of asset-backed security backed by any one or several other ABS, MBS, bonds or loans A Bond's Expected Return Yield is the measure used most frequently to estimate or determine a bond's expected return. Yield is also used as a relative value measure between bonds. There are two primary yield measures that must be understood to understand how different bond market pricing conventions work: yield to maturity and spot rates. A yield-to-maturity calculation is made by determining the interest rate (discount rate) that will make the sum of a bond's cash flows, plus accrued interest, equal to the current price of the bond. This calculation has two important assumptions: first, that the bond will be held until maturity, and second, that the bond's cash flows can be reinvested at the yield to maturity. A spot rate calculation is made by determining the interest rate (discount rate) that makes the present value of a zero-coupon bond equal to its price. A series of spot rates must be calculated to price a coupon paying bond – each cash flow must be discounted using the appropriate spot rate, such that the sum of the present values of each cash flow equals the price. As we discuss below, spot rates are most often used as a building block in relative value comparisons for certain types of bonds. Benchmarks for Bonds Most bonds are priced relative to a benchmark. This is where bond market pricing gets a little tricky. Different bond classifications, as we have defined them above, use different pricing benchmarks. Some of the most common pricing benchmarks are on-the-run U.S. Treasuries (the most current series). Many bonds are priced relative to a specific Treasury bond. For example, the on-the-run 10-year Treasury might be used as the pricing benchmark for a 10-year corporate bond issue. When the maturity of a bond cannot be known with exactness because of call or put features, the bond is frequently priced to a benchmark curve. This is because the estimated maturity of the callable or put-able bond most likely does not coincide exactly with the maturity of a specific Treasury. Benchmark pricing curves are constructed using the yields of underlying securities with maturities from three months to 30 years. Several different benchmark interest rates or securities are used to construct benchmark pricing curves. Because there are gaps in the maturities of securities used to construct a curve, yields must be interpolated between the observable yields. For example, one of the most commonly used benchmark curves is the on-the-run U.S. Treasury curve, which is constructed using the most recently issued U.S. Treasury bonds, notes, and bills. Because securities are only issued by the U.S. Treasury with three-month, six-month, two-year, three-year, five-year, 10-year and 30-year maturities, the yields of theoretical bonds with maturities that lay between those maturities must be interpolated. This Treasury curve is known as the interpolated yield curve (or I-curve) by bond market participants. Other Popular Bond Benchmark Pricing Curves Spot Rate Treasury Curve: a curve constructed using the theoretical spot rates of U.S. Treasuries Swap Curve: a curve constructed using the fixed interest rate side of interest rate swaps Eurodollars Curve: a curve constructed using interest rates derived from eurodollar futures pricing. Agency Curve: a curve constructed using the yields of non-callable, fixed-rate agency debt Yield Spreads for Bonds A bond's yield relative to the yield of its benchmark is called a 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 a certain corporate bond is trading at a spread of 75 basis points above the 10-year Treasury. This means that the yield to maturity of that bond is 0.75% greater than the yield to maturity of the on-the-run 10-year Treasury. Notably, if a different corporate bond with the same credit rating, outlook and duration were trading at a spread of 90 basis points on a relative value basis, the second bond would be a better buy. There are different types of spread calculations used for the different pricing benchmarks. The four primary yield spread calculations are: Nominal Yield Spread: the difference in the yield to maturity of a bond and the yield to maturity of its benchmark Zero-Volatility Spread (Z-spread): the constant spread that, when added to the yield at each point on the spot rate Treasury curve (where a bond's cash flow is received), will make the price of a security equal to the present value of its cash flows Option-Adjusted Spread (OAS): An OAS is used to evaluate bonds with embedded options (such as a callable bond or put-able bond). It is the constant spread that, when added to the yield at each point on a spot rate curve (usually the U.S. Treasury spot rate curve) where a bond's cash flow is received, will make the price of the bond equal to the present value of its cash flows. However, to calculate the OAS, the spot rate curve is given multiple interest rate paths. In other words, many different spot rate curves are calculated and the different interest rate paths are averaged. An OAS accounts for interest rate volatility and the probability of the prepayment of the principal of the bond. Discount Margin (DM): Bonds with variable interest rates are usually priced close to their par value. This is because the interest rate (coupon) on a variable rate bond adjusts to current interest rates based on changes in the bond's reference rate. The DM is the spread that, when added to the bond's current reference rate, will equate the bond's cash flows to its current price. Types of Bonds and Their Benchmark Spread Calculation High-Yield Bonds High-yield bonds are usually priced at a nominal yield spread to a specific on-the-run U.S. Treasury bond. However, sometimes when the credit rating and outlook of a high-yield bond deteriorates, the bond will start to trade at an actual dollar price. For example, such a bond trades at $75.875, as opposed to 500 basis points over the 10-year Treasury. Corporate Bonds A corporate bond is usually priced at a nominal yield spread to a specific on-the-run U.S. Treasury bond that matches its maturity. For example, 10-year corporate bonds are priced to the 10-year Treasury. Mortgage-Backed Securities (MBS) There are many different types of MBS. Many of them trade at a nominal yield spread at their weighted average life to the U.S. Treasury I-curve. Some adjustable-rate MBS trade at a DM, others trade at a Z-spread. Some CMOs trade at a nominal yield spread to a specific Treasury. For example, a 10-year planned amortization class bond might trade at a nominal yield spread to the on-the-run 10-year Treasury, or a Z-bond might trade at a nominal yield spread to the on-the-run 30-year Treasury. Because MBS have embedded call options (borrowers have the free option of prepaying their mortgages), they are frequently evaluated using an OAS. Asset-Backed Securities (ABS) ABS frequently trade at a nominal yield spread at their weighted average life to the swap curve. Agencies Agencies frequently trade at a nominal yield spread to a specific Treasury, such as the on-the-run 10-year Treasury. Callable agencies are sometimes evaluated based on an OAS where the spot rate curve(s) are derived from the yields on non-callable agencies. Municipal Bonds Because of the tax advantages of municipal bonds (usually not taxable), their yields are not as highly correlated with U.S. Treasury yields as other bonds. Therefore, munis frequently trade on an outright yield to maturity or even a dollar price. However, a muni's yield as a ratio to a benchmark Treasury yield is sometimes used as a relative value measure. Collateralized Debt Obligation (CDOs) Like the MBS and ABS that frequently back CDOs, there are many different pricing benchmarks and yield measures used to price CDOs. The eurodollar curve is sometimes used as a benchmark. Discount margins are used on floating rate tranches. OAS calculations are made for relative value analysis. The Bottom Line Bond market pricing conventions are a little bit tricky, but like baseball rules, understanding the basics removes some of the ambiguity and may even make it enjoyable. Bond pricing is really just a matter of identifying a pricing benchmark, determining a spread and understanding the difference between two basic yield calculations: yield to maturity and spot rates. With that knowledge, understanding how various types of bonds are priced shouldn't be intimidating. Article Sources Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. See More Major League Baseball. "Official Baseball Rules: 2023 Edition." Financial Industry Regulatory Authority. "Bonds: Types." New York Public Library. "Fixed Income Securities (Bonds): Collateralized Debt Obligations." McGraw Hill. "Part II Valuation and Capital Budgeting: Chapter 5: How to Value Bonds and Stocks," Pages 1-2. FBS Markets Inc. "Yield Spread: What is Yield Z/G-spread?" Cornell Law School, Legal Information Institute. "Definition: Discount Margin." Take the Next Step to Invest Advertiser Disclosure × The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Part of the Series Guide to Fixed Income Guide to Fixed Income: Types and How to Invest Introduction to Fixed Income The Basics Of Bonds Fixed-Income Security What Is a Fixed-Rate Bond? Interest Rates, Inflation, And Bonds Types of Fixed Income Government Bond Treasury Bond (T-Bond) Bonds vs. Notes vs. Bills Treasury Inflation-Protected Securities (TIPS) Municipal Bond Corporate Bond Convertible Bond High-Yield Bond Junk Bond Callable Bond Understanding Fixed Income Bond Market vs. Stock Market Equity Market vs. Fixed-Income Market Cash vs. Bonds Money Market vs. Short-Term Bonds The Secondary Market: "Over the Counter" Zero-coupon Bond vs. a Regular Bond Fixed Income Investing How Bond Market Pricing Works CURRENT ARTICLE Creating a Modern Fixed-Income Portfolio Whereto Buy Government Bonds Treasury Bonds and Retirement Risks and Considerations 7 Common Bond-Buying Mistakes Interest Rate Risk Pros and Cons of Inflation-Linked Bonds Read more Investing Bonds Partner Links Take the Next Step to Invest Advertiser Disclosure × The offers that appear in this table are from partnerships from which Investopedia receives compensation. 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