Bond trading is really betting on future interest rates. Because interest accumulates over the life of the loan, the worth of the bond is clearly more than the face value. On the other hand, there is also the problem of changes in interest rates over the life of the bond. Because of this, bonds are often traded rather than held to maturity.
Simple Bond Worth
The simplistic worth of a bond is the face value of the bond plus the accumulated interest. it is simplistic because these are not the only two variables. This is the bond's worth without taking time into account. It serves only as a base figure.
In general, bonds lock the investor into a specific rate. You buy a bond with the expectation of getting interest payments plus the final principal at maturity. You want to buy a bond today if and only if you expect rates to fall in the future. If that's the case, then you are holding onto a valuable piece of paper. The worth of the bond has just gone up since your bond is in demand. The bond was bought at a certain rate with the expectation that market rates will fall. When they do, your bond is now worth more, since more people want your bond than the lower-paying bonds presently being offered.
Present value is an important idea in bond investing. If you have a specific profit target in mind, you can figure out how much money you need to invest in bonds today to reach that target in 10 years, for example. If the worth of the bond includes, but is not limited to, the principal plus the coupon rate, you need to figure on the interest payments over time. This means if you need $50,000 to live on per year, you might be able to only invest $40,000 at a time to reach that income including interest payments. If $50,000 yearly is your target amount, then the present value of whatever bonds you buy is much less. Present value does not include interest payments.
Value v. Worth
As always in bond trading, value and worth are distinguished by changes in interest rates over the course of the bond's life. If rates fall, it might make sense to trade this now-valuable bond on the open market for extra cash. This can only mean that the present value of the paper is less, since decreasing interest rates mean -- in effect -- you have made more money. If you are sure interest rates will fall in the future, then buying bonds now to eventually hit your $50,000 yearly target will mean an even lower present value. If you are wrong, you can still make money, but your goal of $50,000 yearly income will just be more distant.
- Jupiterimages/Pixland/Getty Images