Summary
Highlights
A bond represents a loan from the public or banks to a company or government. Key terms include par value (the borrowed amount, typically $1,000), coupon payments (regular interest payments to bondholders), indenture (the legal contract outlining terms like coupon payments and maturity), and maturity date (when the par value is repaid). The market interest rate, which fluctuates daily, is also a crucial factor.
Bonds have fixed coupon payments, meaning the interest rate on an existing bond does not change. However, when market interest rates rise, bonds with lower fixed rates become less valuable. Conversely, if market interest rates fall, existing bonds with higher fixed rates become more valuable than newly issued bonds.
The present value of a bond is determined by adding the present value of its future coupon payments (treated as an annuity) and the present value of its par value. This calculation helps determine a fair selling price for a bond, especially when market interest rates differ from the bond's fixed rate.
Consider a $1,000 bond maturing in 5 years with annual $100 coupon payments (10% interest), while the market interest rate is 8%. The present value of the coupon payments is calculated as an annuity, and the present value of the par value is found by discounting the $1,000 by the 8% market rate over 5 years. Adding these two present values gives the current market value of the bond.
In the example, the present value of the coupon payments is $399.27, and the present value of the par value is $680.58. Summing these, the bond's total present value is $1,079.85. This value is higher than the bond's par value because the market interest rate has dropped, making this specific bond more attractive than new bonds issued at the lower rate.