Bonds are financial instruments used by companies and businesses to raise money for capital. Much like stocks, bonds can be used by corporations to get a good head start in terms of liquidity. It can also be used by investors to grow their money. However, unlike stocks, which are considered equity, bonds are considered loans. Bonds are bought with varying prices, depending on their current value in the market.
This might cause some confusion, because a bond’s actual price might be different from its face value. Computing for the bond price will involve a few things, which will include maturity, length of tenure, risk, and market conditions.
- Consider a bond’s par value. This is the face value of the bond, and is much like the value on a dollar bill. This is the amount of principal that the bond issuer will pay the holder at the end of maturity.
- Consider interest rates. A bond has a coupon rate, which is its interest paid at every year.
- Since bonds are traded instruments, you will need to know how the prices are computed. This is set by different factors, like the risk, the prevailing interest rates, and even the financial condition of the issuer.
- If the bond’s coupon rate is greater than the current interest rate, then the bond’s price increases. If interest grows such that the coupon rate is smaller, then the bond’s price decreases.
- The maturity will also play a role in the bond’s price. The longer the maturity, the lower the price. The shorter the maturity, the higher the price. This is due to uncertainties involving a longer-term holding of the bond, rather than something you can liquidate more quickly.
- The bond issuer’s reputation also plays a big part in whether a bond price will increase or decrease. For example, if the issuer is likely to be bankrupt soon, then your bond price will fall. You can usually check these with credit-rating institutions like Moody’s or Standard and Poor’s. Bonds range between blue chip for the more stable and long-term bonds, to high-risk ones. High-risk bonds usually have higher potential returns, but there’s also a high risk of losing your money if the bond matures.
- Notable examples of bonds that stand on their own are treasury bills. Because government is essentially a no-default entity, you are assured that the bond will be paid at maturity. However, these are usually lower-yield bonds, in terms of interest spread.
Put all these factors together in determining the price of a bond. You will need to understand, though, the concept of a bond’s yield. If its price goes up, the coupon rate is essentially the same—the rate of interest over the face value. This means the yield is lower. If the bond price goes down, then the yield is higher.
Therefore, when you buy a bond at a higher price than face value, your yield is lower. If you buy it at a discounted price, your yield is computed as higher.
Bond prices also sometimes follow interest rates, which in turn, are determined by the Federal Reserve Bank as a reactionary measure against different economic movements like inflation. If interest rates are expected to rise, then bond prices fall. If interest rates are expected to fall, bond prices rise up.