Investors generally buy bonds for two reasons. The first reason is to receive regular interest payments. The second is to get back their principal when a bond matures. What many investors may not understand is how the amount they pay for a bond affects its overall return, or yield to maturity. The simple answer is the lower the price you pay for a bond, the higher the yield to maturity will be.
Bond Pricing
The face value (also known as the par value) of most bonds is $1,000. However, the market value of a bond – what you pay for it – varies from day to day and even from minute to minute. Like stocks, bonds are publicly traded securities, meaning their price can move based on a number of factors. One of the most important determinants of a bond's price is the level of current market interest rates. When interest rates rise, bond prices fall, and vice versa. Thus, you shouldn't expect to pay exactly $1,000 for every bond you buy, and this is an important concept to understand when calculating yield to maturity.
Bond Yield to Maturity
When you buy a bond, the issuer promises to repay the face value of the bond at maturity. If a bond has a face value of $1,000 and you pay $1,000 to buy the bond, your yield to maturity will be the same as the interest rate of the bond. However, if you pay less than $1,000 for that bond, your yield to maturity will be higher. Say, for example, you pay $900 for a bond with a face value of $1,000. In addition to the regular interest payments you receive, you'll also generate a gain of $100 at maturity. This represents an increase in the yield to maturity over the stated interest rate of the bond.
Bonds and Interest Rates
Bond prices go down when interest rates rise because investors will always seek out the highest rates. If you buy a bond that pays 5 percent interest and market rates go up to 8 percent, investors will sell the bond because it isn't worth as much as the newly issued 8 percent bonds. Prices will trend down until the yields become equivalent. The opposite is also true. If you hold a 5 percent bond and rates trend down to 3 percent, investors will pay more for your bond, as it's better to receive 5 percent in interest than 3 percent.
