Bond pricing can be tricky, as there are two components that we have to keep in mind: the yield and the face value. The yield is the actual return on the bond – how much money it is going to make you based on your purchase price. As interest rates rise and fall, so will the face value of your bond because the yield on your bond is fixed and does not change. A good example would be purchasing a $1,000 (the standard price) corporate bond that yields 5% per year and has a 5 year term. I can trade this bond at any time; the term is just how long the bond is active for – I could sell it the day after purchasing it if I wanted to.
If interest rates rise during the duration of this term, it is assumed that new debt could be purchased at a yield higher than 5%, which would drive down the face value of this bond. Why would someone want to purchase a $1,000 bond at 5% when they could purchase a $1,000 at 5.5%? Generally, the face value of the bond would need to be discounted in order to entice someone to purchase it. To compensate, this bond may be sold at $995 because that discount will offset the yield that is being lost by the purchaser from purchasing a rate that is lower than what is currently being offered.
The opposite is also true if interest rates drop during the term – the face value of the bond will go up because the new debt being created is being issued at a rate lower than the rate on this bond.
This inverse pricing makes sense so long as we remember that if interest rates go up, the value of my bond will go down – and vice versa. With interest rates as low as they are today, what do you think that will do to the pricing of bonds in the near future as interest rates rise again? (they’re bound to, at some point)
Bonds are given a rating by independent agencies to let investors know the credit risk associated with the bond. The two most recognized ratings agencies are Moody’s and S&P and each has their own method of assigning a rating to a bond.