Bond Pricing And Duration Basics
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I'm a first-year CFA candidate in the UK, moving from audit into asset management. Can you walk me through the core bond price math? I know prices move with yields, but I keep losing sight of what actually drives the number.
Sure. The core idea is that a bond's price is the present value of its future cash flows: the coupon payments plus the face value at maturity. You discount each cash flow at the market yield required for that bond's risk. If the required yield rises, the discount rate rises and the price falls. If the yield falls, the price rises. In practice, that is why fixed income is so sensitive to interest rate moves. For your CFA mindset, remember the structure: cash flows are fixed, the discount rate is variable, and price is the result.
Why does the coupon matter if the bond is always valued by discounting cash flows? Does a higher coupon just mean more income, or does it also change sensitivity?
It changes both income and sensitivity. A higher coupon means more of the bond's value comes back earlier through coupon payments, so less value is tied up in the final maturity payment. Because earlier cash flows are discounted less, high-coupon bonds usually have lower duration and are less sensitive to yield changes than low-coupon bonds with the same maturity. So coupon affects not just return, but how much price risk you carry. That is important in asset management, where two bonds with the same maturity can behave very differently in a rate shock.
So if yields move up by 1 percent, would a low-coupon bond usually fall more than a high-coupon bond? I want to understand the practical portfolio impact, not just the formula.
Yes, usually it would. A low-coupon bond has more of its value concentrated in the final redemption payment, so it behaves more like a long-duration instrument. That means a given yield rise causes a larger price drop. In a portfolio, this matters because duration tells you roughly how much price change you should expect for a small yield move. If you are managing a UK fixed income mandate, you would use that to position for Bank of England rate expectations and to control how volatile the portfolio is to rate shocks.
How exactly does duration connect the bond price math to portfolio sensitivity? I know there is modified duration, but I keep mixing it up with maturity.
Maturity is just the time until repayment. Duration is more useful because it measures the weighted average time you receive the bond's cash flows, and modified duration translates that into price sensitivity to yield changes. A bond can have the same maturity as another bond but very different duration if the coupons differ. For example, a long-dated gilt with a low coupon will usually have higher duration than a similar maturity corporate bond with a higher coupon. In portfolio terms, duration is the first tool you use to estimate how exposed your bond book is to changes in rates.
That helps. One more thing: if a bond's yield rises, the price drops, but do the coupons cushion that enough to matter over time? I'm trying to connect this to total return rather than just day-to-day price moves.
Yes, the coupons do cushion total return, especially over longer holding periods. A bond investor does not live only on price change: they also earn coupon income, and that income can offset some of the mark-to-market loss if yields rise. This is why you should separate price return from carry. In a rising-rate environment, a bond with a higher coupon may still deliver a better total return than a lower-coupon bond even if both fall in price, because the income stream is stronger. For an asset management role, that distinction is essential when comparing bonds and building expectations for total return under different rate scenarios.