Savers and borrowers meet in financial markets. Two common assets are stocks and bonds. A bond pays interest much like Simple Interest, and its price depends on the percent return that new bonds offer.
Key idea
A bond is a loan: the buyer lends money to a government or company, which promises fixed interest payments (the coupon) and the face value at maturity. A stock is a share of ownership in a company. When market interest rates rise, the prices of existing bonds fall, and when rates fall, bond prices rise.
Why it works
An old bond's payments are fixed when it is issued. Suppose your bond pays \$50 a year on \$1,000, a 5% coupon. If new bonds now pay 7%, no one will pay \$1,000 for yours: for \$1,000 they could get \$70 a year. Your bond's price must drop until its \$50 a year is as good a deal as a new bond. So bond prices and interest rates move in opposite directions. A bond that pays one amount $A$ in a year is worth $\dfrac{A}{1 + r}$ today at market rate $r$: a higher $r$ means a smaller price.
Worked examples
Worked example: A coupon payment
A \$1,000 bond has a 4% coupon rate. What does it pay each year?
- Coupon = face value × coupon rate.
- $1{,}000 \times 0.04 = 40$ dollars a year, fixed for the life of the bond.
Answer: \$40 a year
Worked example: Price and rate
A bond pays \$1,050 one year from now. What is it worth today if the market rate is 5%? If the rate rises to 10%?
- At 5%: $\dfrac{1{,}050}{1.05} = 1{,}000$ dollars.
- At 10%: $\dfrac{1{,}050}{1.10} \approx 954.55$ dollars.
- The rate rose and the price fell.
Answer: \$1,000, then about \$954.55
- Bondholders are lenders: promised fixed payments, paid before owners if the firm struggles.
- Stockholders are owners: they may receive dividends and gain if the company's value rises, but nothing is promised.
Common mistake
Thinking bond prices and interest rates move together, or that buying a bond makes you part owner of a company. Bond prices move opposite to market rates, and a bond is a loan, not ownership. Check: would you pay full price for an old bond paying less than new ones?
Try the bond calculator on the Calculators & Links page: change the market rate and watch the price move the other way.