Corporations and governments issue bonds to raise money to fund projects, or to finance their daily operations. Rather than simply going to the bank for a loan, issuing bonds directly to investors can sometimes be attractive since interest rates are lower, and bonds do not have the same amount of restrictions as bank loans.
Face (or par) value. The face value of a bond can be thought of as its principal. That is to say, the amount you initially loan out, and that you expect to be paid back at the end of the bond’s term. Maturity. The end of a bond’s term is known as maturity. This is the date that the principle is to be returned to the investor of a bond. By knowing a bond’s maturity, you can also understand the length of a bond’s term. Some bonds for example are 10 years in length, others are 1 year, and some are as long as 40 years. Coupon. A coupon can be thought of as a bond’s interest payment. A bond’s coupon is typically expressed as a percentage of the bond’s face value. For example, you may see a 5% coupon on a bond with a face value of $1000. In this case, the coupon would be $50 (0. 05 multiplied by $1000). It is important to remember the coupon is always an annual amount.
Sometimes when you look at bonds, you will see both a yield and a coupon. For example, the bond’s coupon may be 5%, and the bond’s yield may be 10%. This is because the value of your bond can change over time, and yield is the bond’s annual coupon payment as a percent of its current value. Sometimes bond prices go up and down, meaning the price of your bond can change from what your face value is. For example, pretend you purchased a bond with a face value of $1000. This bond pays you a 5% coupon, or $50 per year. Pretend now that the price of your bond dropped to $500 in the first year due to a change in interest rates in the marketplace. The yield would then be 10%. Since a bond’s yield is the coupon payment as a percent of its current value, the coupon ($50) would be 10% of the current value ($500). As bond prices drop the percent yield goes up. [3] X Research source The reason bond market prices change is due to fluctuations in the market. For example, if long term interest rates rise from 5% (the coupon rate also) when the bond was purchased, the market price of a $1000 bond will fall to $500. Since the bond’s coupon is only $50, the market price must fall to $500 when the interest rate is 10% to be marketable. While this may seem complex, you do not need to worry. This is because when calculating a bond’s interest rate, you only need to worry about the coupon. If you noticed in both examples, while the percent is different, the payment is the same. Keep in mind that if you hold the bond until maturity and do not sell, you will receive back your principal, regardless of what happens to the price of the bond during the term.
Pretend that in this case, the face value of the bond is $1000. This means you “loaned out” $1000, and expect $1000 back at the bond’s maturity.
The coupon rate established when the bond was issued remains unchanged and is used to determine interest payments until the bond reaches maturity. In this case, assume the coupon is 5%.
For example, if the bond’s face value is $1000, and the interest rate is 5%, by multiplying 5% by $1000, you can find out exactly how much money you will receive each year. Remember when multiplying a number by a percent, to convert the number to a decimal. For example, 5% would be 0. 05. $1000 multiplied by 0. 05 would equal $50. Therefore, your annual interest payment is $50.
This information is stated when you purchase the bond. If a bond pays interest twice a year, the annual payment would be divided by two. In this case, every six months you can expect $25.
In this case, $50 divided by 12 is $4. 16, which means you would receive $4. 16 monthly. You earn the interest only for the days you own the bond. If you buy a bond between interest payments, the market price will include the interest owed to the previous owner for the days he or she held the bond.
