Face value, also known as the par value, is equal to a bond's price when it is first issued. After that, the price of the bond fluctuates in the market in accordance with changes in interest rates while the face value remains fixed.

Key Takeaways

  • Face value is equal to a bond's price when it is first issued, but the price changes after that.
  • As the bond's price fluctuates, the price is described relative to the original par value, or face value; the bond is referred to as trading above par value or below par value.
  • Three factors that influence a bond's current price are the issuer's credit rating, market interest rates, and the time to maturity.

Basic Terms

The various terms surrounding bond prices and yields can be confusing to the average investor. A bond represents a loan made by investors to the entity issuing the bond, with the face value being the amount of principal the bond issuer borrows. The principal amount of the loan is paid back at some specified future date. Interest payments are made to the investor at regular, specified intervals during the term of the loan, typically every six months.

A bond is a fixed-rate security or investment vehicle. The interest rate to a bond investor or purchaser is a fixed, stated amount. However, the bond's yield, which is the interest amount relative to the bond's current market price, fluctuates with the price. As the bond's price varies, the price is described relative to the original par value, or face value; the bond is referred to as trading above par value or below par value.

The need to change the yield to reflect current market conditions drives the changes in price. Unfavorable developments demand higher yields, so bond prices must fall. In the same way, improvements in the company's situation allow it to raise funds at lower rates. Hence, the prices of existing bonds rise.

Factors That Influence Bond Prices

Three factors that influence a bond's current price are the credit rating of the issuer, market interest rates, and the time to maturity. As the bond nears its maturity date, the bond price naturally tends to move closer to par value.

The credit rating for a bond is determined by bond rating companies, such as Moody's or Standard & Poor's. Lower ratings generally cause a bond's price to fall since it is not as attractive to buyers. When the price drops, that action tends to increase the bond's appeal because lower-priced bonds offer higher yields.

Any change in public perception of a firm's creditworthiness can influence the price of its bonds. In many cases, bond rating downgrades simply confirm what investors already suspected.

Prevailing market interest rates change after a bond is issued, and bond prices must adjust to compensate investors. If interest rates rise, then bond prices must fall. Suppose a three-year bond pays 3% when it is issued, and then market interest rates rise by half a percentage point a year later. In order to sell the bond in the secondary market, the price of the bond will have to fall about 1% (extra 0.5% per year x 2 years), so it will be trading at a discount to face value. New bonds from firms with similar credit quality are now paying 3.5%. The old 3% bond still pays 3% in interest, but investors can now look forward to an extra 1% when the bond matures. Similarly, the price of the bond must rise if interest rates fall.

Time to maturity also usually influences bond prices. However, the exact effect depends on the shape of the yield curve. A normal yield curve features lower interest rates for short-term bonds and higher interest rates for long-term bonds. This situation is considered normal because longer-term bonds have higher interest rate risk. Investors will usually demand higher interest rates as compensation for taking that risk. However, the yield curve may flatten if there is widespread anticipation that interest rates will remain unchanged. If enough investors believe interest rates are going to fall, an inverted yield curve can occur.

The Bottom Line

The most important difference between the face value of a bond and its price is that the face value is fixed, while the price varies. Whatever price is set for face value remains the same until the bond reaches maturity. On the other hand, bond prices can change dramatically. In theory, a spectacular decline in credit quality can send the bond price to zero. In actual practice, secured bondholders are paid first when a business is liquidated, so some funds are usually recovered. Repeated interest rate hikes can also take a toll on bond prices. Finally, there is some good news on time to maturity. Bond prices normally rise as bonds approach maturity.