When you buy a bond, you are loaning money to the issuer. Since a bond is a loan, the interest paid to the bondholder is payment for lending the money. The interest payable is stated as a percentage of the amount borrowed, known as the par value of the bond.
As a result, a bond with a par value of $1,000 and an interest rate of 10 percent promises to pay $100 per year in interest until the bond matures, at which point the original par value ($1,000) is returned to the bondholder.
What Happens When Interest Rates Rise (or Fall)
Although a bond has a fixed par value, the prices at which it is bought and sold in the financial market may be either higher, lower or equal to par. For example, if the market interest rate is 10 percent, then a bond paying 10 percent interest will sell for par value. However, if the market interest rate rises to 11 percent, no one will pay par value because identical bonds that pay an 11 percent rate are available.
This causes the price of the bond to fall until the interest payable plus the gain earned by the difference between par value and the lower price paid yields an 11 percent return.
For the same reason, when the market interest rate falls, bond prices increase. This scenario demonstrates the basic principle between interest rates and bond prices; when one goes up the other goes down. Because market interest rates fall and rise constantly, so do bond prices.
Does the Par Value Change?
It's important to note that the par value of a bond, the amount you will receive at maturity, will never change regardless of the market rate or bond price.
If the market interest rate is higher than the interest payable on a bond, the bond is said to be selling at a discount (below par value). If the market interest rate is lower than the interest payable on a bond, it is said to be selling at a premium (above par). And, if the market interest rate equals the interest payable, the bond will sell for par. The par value itself, and thus the value of a bond payable upon maturity, will never change, regardless of the bond price or market interest rates.
(For further reading on this subject, please see our Bond Basics Tutorial.)