While you can probably pick up a lot about how the stock market works simply from following the news, the same cannot be said for the bond market. Because it is considered less exciting, the bond market doesn’t get a lot of coverage. But it is essential that you understand the basics. Here are some of the most important bond-related terms.
Par value is the amount that will be received at the time of maturity. It is also known as the principal, face value, or par value. Par value will vary depending on the type of bond. Most corporate bonds have a $1000 face value, while some government bonds will carry a much higher par value.
Savings bonds can be purchased for sums under $100, so there is a wide variety of options. When the bond matures and the lump sum is returned, the debt obligation is complete. It is important to remember that bonds are not always sold at par value. In the secondary market, a bond’s price fluctuates with interest rates. If interest rates are higher than the coupon rate on a bond, the bond will have to be sold below par value (at a “discount”). If interest rates have fallen, the price will be higher.
Maturity is the length of time before the principal is returned on a bond. It is also called term-to-maturity. At the time of maturity, the issuer is no longer obligated to make interest payments. Maturities range significantly, from 1 month for some municipal notes to 40+ years for some corporate bonds. When evaluating your goals, keep in mind that bonds of different maturities will behave somewhat differently. For example, bonds with long-term maturities will be more sensitive to changes in interest rates. Shorter-term bonds are more stable and, because you are more likely to hold it to maturity, are more predictable. There are some circumstances where a bond will be “called” before maturity.
The coupon rate is the interest rate that is paid out to the bondholder. The name derives from the old system of payment, in which bondholders would need to send in coupons in order to receive payment. The coupon is set when the bond is issued and is usually expressed as an annual percentage of the par value of the bond. Payments usually occur every six months, but this can vary. If there is a 5% coupon on a $1000 face value bond, the bondholder will receive $50 every year. If two bonds with equal maturities and face values pay out different coupons, the prices of these bonds will behave differently in the secondary market. For example, the bond with a lower coupon rate will be less expensive because the bondholder is going to be getting more of his/her return from the return of principal at maturity than will the holder of a bond with a higher coupon. There are some bonds that do not pay out any coupons; these are called zero-coupon bonds.