What Is a Bond?

Bonds are simply IOUs issued by firms and governments. Issuing bonds is a method of borrowing money to finance economic activity. The entity issuing the bond promises to pay the bondholder an agreed-upon sum (called the "principal") either on a specific date or in installments over a specified period, during which time a fixed interest rate may be paid with payments due on certain dates. Most bonds pay a fixed return per year until the bond matures, at which time the owner is entitled to receive payment of the face value of the bond. The fixed return is expressed as a percent of the face value. The U.S. Coupon Bond shown here is a typical government bond. The face value of this bond is $100.000. and the bond was issued at an interest rate of 3.5 percent. Until the bond matured, the owner was entitled to a fixed yearly return of $3500 (3.5 percent of $100,000. In this case, interest was payable semiannually (in two payments of $1750 upon redemption of the coupons at the Treasury Department or a designated agency.

Even though most bonds are issued over the long term. the face value of a bond can be redeemed before it matures. Each day, sales of previously issued bonds comprise the majority of bonds bought and sold on the bond market. Like most stocks traded on the stock market, new issues of bonds account for only a small portion of all bond sales.

How Does a Change in the Market Interest Rate Affect Band Prices?

Suppose that you have just bought a newly issued $1000 bond that pays 8 percent on the issue price. As long as you own the bond, you are entitled to a fixed return of S80 per year. Let us also assume that after you have held the bond for one year and have collected your $80 interest for that year, the market interest rate, for whatever reason, increases to 10 percent? How will the increase in the interest rate affect the market price of your bond? Since bond purchasers can now earn 10 percent interest if they buy newly issued bonds, they will be unwilling to pay more than $800 for your bond, which pays only $80 interest per year. After ail, why would anyone pay $1000 for a bond that yields only $80 interest per year when the same $1000 will now purchase a bond that yields $100 (10 percent) per year? Once the interest rate has risen to 10 percent, your 8 percent, $I000 bond will no longer sell for its original value. The market value of your bond will fall to $800. You have experienced a $200 capital loss on the bond during the year. Rising market interest rates cause bond prices to decline.

On the other hand, falling interest rates will cause bond prices to rise. If the market interest rate had fallen to 6 percent, what would have happened to the market value of your bond? (Hint: $80 is 6 percent of $1333.) Bond prices and interest rates are inversely linked to each other.

3. The astute reader will recognize an oversimplification in this discussion. In reality, the economy supports a variety of interest rates, which usually tend to move together.