One of the most basic concepts that investors should become familiar with is how bonds are priced. Bonds do not trade like stocks. 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.
Pricing on Premium Bonds and Discount Bonds
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.
Bond Duration and Pricing
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 toward 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.
Pricing on Callable Bonds
Investors considering how the approach of a maturity date will affect the price of a bond should also be aware of the effect that a call feature has on the bond. Callable bonds can be redeemed prior to the date of maturity at the issuer’s discretion.
Because of the possibility for early redemption, if interest rates have gone down, the bond's price will act in a way that reflects an approach to maturity; this situation makes it more appealing to the issuer to redeem the bond early. If interest rates have gone up, an approaching call date will not greatly affect the bond's price, as the issuer is less likely to exercise the option to call the bond.