How are bond prices determined?
Bond price determination can be a very complex subject that extends beyond the scope of this publication. But in general, bond prices are determined by many variables, including: prevailing and expected interest rates; current interest rate policy; supply and demand for bonds; particular classes or types of bonds; liquidity; the quality of the credit; date of maturity; and tax status. It is important to note that newly issued bonds usually sell at or near their nominal face value, or principal value. But it is equally important to note that any bonds selling in the secondary markets may trade at different prices, given the demand for the particular bond, and may actually be sold at a premium (priced above its face value), or sold at a discount (priced below its face value).
What about bond interest rates?
Bonds have a stated interest rate that may be dispersed and paid to a bondholder in a few different ways. Bonds may pay interest to investors at a fixed-rate or a floating rate, whereby the rate is adjusted periodically and tied to bond benchmark interest rate indexes such as the London Interbank Offered Rate (LIBOR), U.S. Treasury Bills, or other benchmarks. Please consult your bond expert for further information on the interest rates of bonds you may be considering.
What is a "coupon payment"?
When a bond issuer pays the bond buyer interest periodically on a bond investment during its term, it is called a coupon payment. For example, the issuer of a $10,000 bond paying 8% would send a coupon payment of $400 twice a year to the bond investor. When the bond matures, in addition to these semi-annual payments, the bond investor will receive the full face value of the bond.
What are the different categories of the term or maturity of bonds?
Bond maturity terms usually fall anywhere from one to thirty years. Short-term bonds typically mature in less than five years. Medium-term bonds reach maturity in five to twelve years. Long-term bonds mature in periods greater than twelve years.
What is a "zero coupon bond"?
Some bonds that do not make regular coupon payments, but instead pay all interest compounded when the bond matures, are called zero coupon bonds. These types of bonds are typically sold at a substantial discount to their face value, and all accrued interest and the principal are paid to the investor when the bond reaches maturity. It is important to note that the prices of zero coupon bonds tend to fluctuate more than their coupon-paying counterparts.
Why does the term of a bond matter when I think about risk?
The term of a bond matters greatly when you invest because of the length of time you must wait before the bond's principal is paid back. Typically, short-term bonds are less risky, since the principal is paid back sooner than higher-risk, medium- and long-term bonds. But to compensate investors, in exchange for accepting these risks, medium- and long-term bonds tend to offer higher returns and interest rates to bondholders.