When interest rates go up, bonds you already own go down. It sounds backward until you try to sell a 5% bond in a 7% world. This week you see why.
Learning objectives. After this week you can (1) explain what a bond is; (2) compute its annual coupon; and (3) explain why bond prices and yields move in opposite directions.
Remember this: bond prices and yields move in opposite directions.
1) What a bond is
A bond is a loan from an investor to a borrower, the issuer. The issuer pays regular interest, the coupon, and repays the face value (also called par) at maturity. Hold a bond to maturity without a default and you get the face value back. A stock is ownership; a bond is debt.
2) The coupon
Annual Coupon = Face Value × Coupon Rate
A $1,000 bond with a 5% coupon pays 1,000 × 0.05 = $50 a year. Scale it up: a racing team that raised $9,000,000 at a 7% coupon would owe 9,000,000 × 0.07 = $630,000 every year, win or lose.
3) Prices and yields
The yield is the return an investor earns on the bond. Say you own a 5% bond and market rates rise to 7%. New bonds now pay 7%, so nobody pays full price for yours: its price falls until its yield matches the market. When rates fall, the price of your bond rises.
- Below face value, a bond trades at a discount.
- Above face value, at a premium.
4) Risk and return
Riskier borrowers must offer higher yields to attract lenders. Government bonds are usually safer than corporate bonds, so they pay less. If an issuer starts to look safer, investors accept a lower yield, so its bond price goes up. The yield curve plots yields against time to maturity.
Quick self-check
(a) A $1,000 bond with a 6% coupon pays how much a year? (b) Market rates fall. Do existing bond prices rise or fall? (c) A bond sells for $970 with a $1,000 face. Discount or premium? (Answers: $60; rise; discount.)
Common mistakes
- "Rates up, bonds up." It is the reverse: rates up, existing bond prices down.
- Mixing up coupon and face. The face is repaid once; the coupon is paid every year.
- Calling a bond ownership. Bondholders are lenders; stockholders are owners.
This week in the arena
Real racing teams fund big projects by issuing bonds. Yours runs on cash, so imagine one: a bond the size of a car investment you'd like to make (the second car costs $9M). What coupon would investors want from a team with your record, and what would it cost you each year?