A:

One of the most basic concepts that investors should become familiar with is how bonds are priced. Bonds do not trade like stocks do. The pricing mechanisms that cause changes in the bond market are not nearly as intuitive as seeing a stock or mutual fund rise in value. Bonds are loans; when you purchase a bond, you are making a loan to the issuing company or government. Each bond has a par value, and it can either trade at par, at premium or at discount. The interest paid on a bond is fixed, but the yield – the interest payment relative to current bond price – fluctuates as the bond's price fluctuates.

Put simply, bond prices fluctuate on the open market in response to supply and demand for the bond. The price of a bond is determined by discounting the expected cash flow to the present using a discount rate. Three primary influences on bond pricing on the open market are supply and demand, age-to-maturity and credit ratings.

Bonds are issued with a set face value and trade at par when the current price is equal to the face value. Bonds trade at a premium when the current price is greater than the face value. For example, a $1,000 face value bond selling at $1,200 is trading at a premium. Discount bonds are the opposite, selling for lower than the listed face value.

Bonds that are priced lower have higher yields, and they are therefore more attractive. For instance, a $1,000 face value bond that has a 6% interest rate pays $60 in annual interest every year regardless of the current trading price. Interest payments are fixed. When the bond is currently trading at $800, that $60 interest payment creates a present yield of 7.5%. Since you would rather pay $800 to earn $60 than pay $1,000 to earn that same $60, bonds with higher yields are better buys.

The age of a bond relative to its maturity has a significant effect on pricing. Bonds are paid in full (at face value) when they mature, though there are options to call, or redeem, some bonds before they mature. Since a bondholder is closer to receiving the full face value as the maturity date approaches, the bond's price moves towards par as it ages.

Age and demand for bonds influence prices, and the ratings provided to bonds and their issuers also have a large impact. There are three primary rating agencies, and the ratings that they assign act as signals to investors about the creditworthiness and safety of the bonds. Since bondholders are less likely to purchase bonds with poor ratings (and thus a lower chance of repayment by the issuer), the price of those bonds is likely to fall.

RELATED FAQS
  1. Why is my bond worth less than face value?

    Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate ... Read Answer >>
  2. What happens to the price of a premium bond as it approaches maturity?

    Learn how bonds trade in regard to premiums and discounts, and how bond prices shift closer to par value as bonds approach ... Read Answer >>
  3. Will the price of a premium bond be higher or lower than its par value?

    Find out why the selling price of a premium bond is always higher than its par value, including how changing interest rates ... Read Answer >>
  4. What are the key factors that will cause a bond to trade as a premium bond?

    Learn about the primary factor that can cause bonds to trade at a premium, including how national interest rates affect bond ... Read Answer >>
  5. How does the effective interest method treat the interest on a bond?

    Find out why you should look at the effective interest of a bond rather than simply relying on its stated coupon rate when ... Read Answer >>
Related Articles
  1. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  2. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  3. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  4. Investing

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  5. Investing

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  6. Investing

    Are Bonds Selling At A Premium A Good Investment?

    A bond with a par value – or face value -- of $1,000 is selling at a premium when its price exceeds par.
  7. Investing

    The Best Bet for Retirement Income: Bonds or Bond Funds?

    Retirees seeking income from their investments typically look into bonds. Here's a look at the types of bonds, bond funds and their pros and cons.
RELATED TERMS
  1. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  2. Bond Discount

    The amount by which the market price of a bond is lower than ...
  3. Bond

    A debt investment in which an investor loans money to an entity ...
  4. Bond Valuation

    A technique for determining the fair value of a particular bond. ...
  5. Premium Bond

    1) A bond that is trading above its par value. A bond will trade ...
  6. Bond Ladder

    A portfolio of fixed-income securities in which each security ...
Hot Definitions
  1. Pro-Rata

    Used to describe a proportionate allocation. A method of assigning an amount to a fraction, according to its share of the ...
  2. Private Placement

    The sale of securities to a relatively small number of select investors as a way of raising capital.
  3. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  4. Backward Integration

    A form of vertical integration that involves the purchase of suppliers. Companies will pursue backward integration when it ...
  5. Pari-passu

    A Latin phrase meaning "equal footing" that describes situations where two or more assets, securities, creditors or obligations ...
  6. Interest Rate Swap

    An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for ...
Trading Center