Corporations and governments borrow money from investors by issuing bonds. Borrowers promise to pay back the loans and to pay a specific rate of interest.
Bonds are often referred to as fixed income securities because the rate of interest is often fixed (not variable) and the term of the bond is also fixed. The term specifies the length of the loan just like a term loan or mortgage from your bank will have an end date when the loan must be paid off.
A 10-year $1,000 U.S. Treasury bond issued today will mature in 10 years at the end of the term, and the principal ($1,000) will be returned to the investor. The bondholder receives interest until the bond is sold or held to term (maturity). Today, the prevailing market interest rate for 10-year U.S. Treasury Bonds is 2%, meaning the bond holder will earn $20 per year in this example.
Bond terms come in three categories:
- Short-Term (usually 2 years or less)
- Intermediate-Term (2 to 10 years)
- Long-Term (more than 10 years)
Usually, longer-term bonds pay higher interest rates to compensate investors for tying up their money for a long time.
When bonds are issued, they are sold at par value (face value) usually in $1,000 units. After issue, bonds trade in the secondary market, which gives bondholders the option of selling bonds before their maturity date.
The value of a bond in the secondary market depends in part on the prevailing market interest rates. For example:
- Take a corporate bond issued at par value of $1,000 with a term of 10 years and an interest rate of 6%.
- Two years later, if the prevailing market interest rate for similar corporate bonds increases to 8% and the bondholder wants to sell the 6% bond in the secondary market, other investors will only bid around $885 for the $1,000 bond because it is paying less than the prevailing market interest rate.
- Three years later, if the prevailing market interest rate for corporate bonds falls to 3% and the bondholder wants to sell the 6% bond in the secondary market, the $1,000 bond will fetch about $1,137 because it is paying more than the prevailing market interest rate.
Bondholders want prevailing market interest rates to fall because this causes the value of their bonds to increase in the secondary market. Bondholders don’t want prevailing market interest rates to rise because this causes the value of their bonds to decrease in the secondary market. As a result, bond prices move inversely to interest rates.