Changes

Often, bonds are issued by corporations or governments. The issuer offers them for sale at a specified amount (the ''face value,'') often $1000. The issuer promises to pay that amount back on a specific date (the ''maturity''), and to make regular, specified interest payments—often four times a year (''quarterly'')—in the meantime.

Often, bonds are issued by corporations or governments. The issuer offers them for sale at a specified amount (the ''face value,'') often $1000. The issuer promises to pay that amount back on a specific date (the ''maturity''), and to make regular, specified interest payments—often four times a year (''quarterly'')—in the meantime.

For example, someone who buys a $1000 bond in December, 2007, with a five year maturity and a "coupon interest" of 6% per year:

For example, someone who buys a $1000 bond in December, 2007, with a five year maturity and a "coupon interest" of 6% per year

*Pays $1000 to buy the bond in December, 2007

:—pays $1000 to buy the bond in December, 2007

*Receives interest payments of $15 in March, June, September, and December of 2008, 2009, 2010, 2011, and 2012

:—receives interest payments of $15 in March, June, September, and December of 2008, 2009, 2010, 2011, and 2012

*Receives the $1000 back in December of 2012,

:—receives the $1000 back in December of 2012,

for a total of $1300.

for a total of $1300.

To see why this is so, consider the bond example above. Suppose that after three years the bondholder wishes to sell the bond to somebody else. How much is the bond worth? Unlike stocks, there is very little judgement or guesswork involved, just a financial calculation based on the numbers. The bondholder who buys the bond in, say, December of 2010 knows that the bond is going to pay him

To see why this is so, consider the bond example above. Suppose that after three years the bondholder wishes to sell the bond to somebody else. How much is the bond worth? Unlike stocks, there is very little judgement or guesswork involved, just a financial calculation based on the numbers. The bondholder who buys the bond in, say, December of 2010 knows that the bond is going to pay him

*Interest payments of $15 in March, June, September, and December of 2011, and 2012

:—interest payments of $15 in March, June, September, and December of 2011 and 2012

*$1000 when the bond matures in December of 2012.

:—$1000 when the bond matures in December of 2012.

What should he pay for the bond? This is a standard financial calculation called the ''net present value'' of an income stream. Most spreadsheet programs provide a function for calculating it. It turns out that the calculation depends on one more variable: the interest rate. This bond has a coupon interest rate of 6%. If the prevailing interest rate is 6%, it turns out that the value of the bond is exactly its face value: $1000. In theory, a buyer should be willing to pay $1000 for the bond.<ref>In reality, markets being what they are, the buyer won't be willing to pay quite that much, and the brokerage will definitely want a commission on the trade.</ref>.  

How much should he pay for the bond? This is a standard financial calculation called the [[net present value]] of an income stream. Most spreadsheet programs provide a function for calculating it. It turns out that the calculation depends on one more variable: the interest rate. This bond has a coupon interest rate of 6%. If the prevailing interest rate is 6%, it turns out that the value of the bond is exactly its face value: $1000. In theory, a buyer should be willing to pay $1000 for the bond.<ref>In reality, markets being what they are, the buyer won't be willing to pay quite that much, and the brokerage will definitely want a commission on the trade.</ref>.  

But if the interest rate is lower than 6%, the bond is worth more than $1000. For example, if the interest rate were '''zero...''' if the buyer was just as happy to get $1000 two years from now as to get it today... then the value of the bond would be just the total value of all of the future payments, or $1120. On the other hand, if the prevailing interest rate is higher than 6%, the value of the bond is less than its face value. For example, suppose the interest rate has risen to 12%, a rather large change. Why would a buyer pay $1000 to receive interest payments of $15 every quarter when he could buy a newly-issued 12% bond and receive interest payments of $30? The net present value calculation shows that the value of the bond is only $894.70.

But if the interest rate is lower than 6%, the bond is worth more than $1000. For example, if the interest rate were '''zero...''' if the buyer was just as happy to get $1000 two years from now as to get it today... then the value of the bond would be just the total value of all of the future payments, or $1120. On the other hand, if the prevailing interest rate is higher than 6%, the value of the bond is less than its face value. For example, suppose the interest rate has risen to 12%, a rather large change. Why would a buyer pay $1000 to receive interest payments of $15 every quarter when he could buy a newly-issued 12% bond and receive interest payments of $30? The net present value calculation shows that the value of the bond is only $894.70.