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3.5 Matrix Pricing of a Bond

Matrix pricing is an estimation process used for bonds that are not actively traded.

In matrix pricing, market discount rates are extracted from comparable bonds (i.e., bonds with similar time-to-maturity, coupon rate, and credit quality). Once the appropriate discount rate (YTM) is found for the bond, the bond price can be calculated.

Matrix pricing is also used in underwriting new bonds to get an estimate of the required yield spread over the benchmark rate.

  • The benchmark rate is typically the yield-to-maturity on a government bond having the same, or close to the same, time-to-maturity.
  • The spread is the difference between the yield-to-maturity on the new bond and the benchmark rate.
  • The yield spread is the additional compensation required by investors for the difference in the credit risk, liquidity risk, and tax status of the bond relative to the government bond. This spread is sometimes called the "spread over the benchmark."
  • Yield spreads are often stated in terms of basis points (bps). There is usually a different yield spread for each maturity and for each credit rating.
  • The term structure of credit spreads is the relationship between the spreads over the "risk-free" (or benchmark) rates and times-to-maturity.

Lesson Wrap-Up

This lesson should leave you able to explain the matrix pricing of a bond in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

  1. Explain matrix pricing of a bond in your own words.
  2. State one exam-style risk, valuation, or market implication of the matrix pricing of a bond.