Investors often categorize bonds that are traded on bond markets by issuer: corporate, municipal or Treasury bonds. Whichever type of bond you invest in, chances are you are interested mainly in the income the bond provides. You must understand the difference between par (or face) value and a bond’s market price to make good investment choices. A change in price relative to par value is what determines the rate of return you get from a bond investment.
Bonds are debt securities that are issued for a limited period of time referred to as the bond’s maturity. The par value (or face value) is the amount of money the issuing organization must pay the bond holder to retire the debt when the bond matures. Each bond pays a fixed annual sum of money, called the coupon, that is a percentage of the par value. For example, a corporate bond that has a par value of $1,000 might pay a coupon of $60, or 6 percent of face value.
As investors buy and sell bonds, the market prices fluctuate and are rarely the same as the par value. When a bond price is greater than the par value, investors say the bond is trading at a premium. If the price drops below the par value, the bond is said to be selling at a discount. When bonds are approaching maturity, the price gets closer and closer to the par value. That’s because the issuer will soon pay off the bonds at par value.
The coupon amount does not change when a bond price changes. This creates an inverse relationship between the effective rate of interest (called the yield) and the bond’s price. That is, when the bond price goes down, the yield goes up. If the price goes up the yield goes down. Suppose a $1,000 par value bond with a 6 percent coupon sells at a premium for $1,200. Divide the coupon of $60 by $1,200 to find the yield, which here is 5 percent. If the bond prices should fall to $800, you again divide the coupon by the price. However, this time you get a yield of 7.5 percent.
There are two major factors that affect bond prices. Interest rates are the most important. When prevailing interest rates go up, bond prices tend to fall as investors switch their money into securities paying the higher rates. A bond’s price will stabilize when the yield rises to a figure comparable to the new interest rate level. The opposite happens if prevailing rates fall -- bond prices tend to go up. A second factor affecting bond prices is credit risk. If a bond issuer is in good financial condition, it will be rated as a good risk by services like Moody’s and Standard & Poor’s. If the issuer has financial problems and the rating is downgraded, bond prices usually fall because investors want a higher return to offset the added risk.
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