When you’re buying bonds, there is one fundamental principle you need to know and understand. The principle is as follows: bond prices and interest rates move in opposite directions.
That’s right. When interest rates go up, the price of your bond goes down. And when interest rates go down, the price of your bond goes up. Let’s look at why.
Lets assume you have a bond with a par value (beginning, face value) of $1,000. You’re earning 5% on it. Now there are three scenarios that can happen that will affect the price of your bond:
Interest rates will increase. In this case, the price of your bond will fall. Why? Supply and demand is why. When something is in high demand, its price rises. When something has little demand, its price falls. If interest rates elsewhere in the market rise to, let’s say 7%, why would anyone want to buy your bond that’s only offering 5% interest? As you can see, there’s now less demand for your bond. So the price fell as interest rates increased.
Interest rates will decrease. You can probably figure out what will happen in this case, but lets see what happens anyway. Assume interest rates fall to 3%. Now your bond is bringing you more income than the rest of the market. Because of this, investors are willing to pay more for your bond than its $1,000 par value. Why would someone want to pay more than the par value of the bond? Because they can earn more interest with your bond. So as interest rates decreased, the price of your bond rose. Get it?
Terms You Should Know
Now we have to define some terminology. As we already learned, the beginning price of a bond, its face value, is also called its par value. This is the amount you paid to get the bond and the amount the company/government/whatever will repay the owner of the bond when it matures. The date the bond expires or comes due is called the date of maturity.
So what do you call a bond that’s selling for more or less than its par value? If the bond’s price fell (meaning interest rates rose in relation to your bond’s interest rate) and you try to sell your bond, you’ll be selling your bond at discount. This makes sense, right? If you sell something for less than what you paid for it, you’re selling it at a discount.
How about if you’re selling it for more than par value? In that case, you’re selling the bond at a premium. This term is also pretty straightforward. When something is expensive or more desired, it’s usually defined as premium in some way.
Pricing Bonds – The Magic Number 100
Bond prices are often defined in relation to 100. When a bond is at par value, they sell it’s selling at 100. If a bond is selling at a premium, its price will be defined above 100. For example, if a bond is selling at a 3% premium, it will be a bond selling at 103. Note that this 3% is NOT an interest rate. It is the premium added to the price of the bond. So if this is a $1,000 par value bond selling at a 3% premium, the bond is selling for $1,030.
Discounted bonds are just the opposite. Their prices are defined below 100. So a bond selling at a 3% discount will be priced at 97. In other words, the bond is selling for 97% its par value. A $1,000 par value bond selling at 97 would be going for $970. Clear as mud? Good!
Now that you know the basics of bond investing, you’ll understand what the bond listings are talking about when they say a bond is selling at 102. And more importantly, you’ll understand why it’s selling at 102!
Next time we’ll look at another type of bond: the deep discount bond.
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