You will want to research bonds before investing your money. Here are the first three things you will want to find out about a bond:
What is its face value?
What is the coupon rate?
How much are you being asked to pay for the bond?
These can all be ascertained quite readily, either by looking at the bond offer itself or by having a conversation with the broker.
The bond’s face value
Also known as par value or the principal, the face value is the original dollar amount of the bond. This is the amount that the bond issuer promises to pay the bond buyer at maturity. The face value of the vast majority of bonds in today’s market is $1,000. But note that a $1,000 par value bond doesn’t necessarily have to sell for $1,000.
After the bond is on the open market, it may sell for an amount above or below par. If it sells above par, it’s known as a premium bond. If it sells below par, it’s known as a discount bond.
Know this: Discount bonds are discounted for a reason . . . or, perhaps, two or three reasons. Most commonly, the discounted bond isn’t paying a very high rate of interest compared to other similar bonds. Or the issuer of the bond is showing some signs of financial weakness that could potentially lead to a default.
Don’t think you are necessarily getting a bargain by paying less than face value for a bond. Chances are, you aren’t.
The bond’s coupon rate
The coupon rate is the interest rate the bond issuer (the debtor) has agreed to pay the bondholder (the creditor), given as a percent of the face value. The term coupon rate refers to the fact that in the old days, bonds had actual coupons attached that you would rip off at regular intervals to redeem for cash.
Bonds no longer have such coupons; in fact, they aren’t printed on paper anymore. Bonds are all electronic, but the term remains.
The coupon rate never changes. That’s the reason that bonds, like CDs, are called fixed-income investments, even though the term is a bit of a misnomer. A 5 percent bond always pays 5 percent of the face value (which is usually $50 a year, typically paid as $25 every six months).
The bond doesn’t have to be bought or sold at par. But the selling price of a bond doesn’t affect the coupon rate.
Know this: The coupon rate, set in stone, tells you how much cash you’ll get from your bond each year. Simply take the coupon rate and multiply it by the face value of the bond. Divide that amount in half. That’s how much cash you’ll typically receive twice a year. A $1,000 bond paying 8 percent gives you $40 cash twice a year.
The bond’s sale price
In general, a bond sells at a premium (above face value) when prevailing interest rates have dropped since the time that bond was issued. If you think about it, that makes sense. Say your bond is paying 6 percent, and interest rates across the board have dropped to 4 percent. The bond in your hand, which is paying considerably more than new bonds being issued, becomes a valuable commodity.
On the other hand, when general interest rates rise, existing bonds tend to move to discount status (selling below face value). Who wants them when new bonds are paying higher rates?
Don’t ask why, but bond people quote the price of a bond on a scale of 100. If a bond is selling at par (face value), it will be quoted as selling at 100. But that doesn’t mean that you can buy the bond for $100. It means you can buy it at par.
On a $1,000 par bond, that means you can buy the bond for $1,000. If the same bond is selling at 95, that means you’re looking at a discount bond, selling for $950. And if that bond is selling for 105, it’s a premium bond; you need to fork over $1,050.
Know this: Most investors put too much weight on whether a bond is a discount bond or a premium bond. Although it matters somewhat, especially with regard to a bond’s volatility, it doesn’t necessarily affect a bond’s total return.
Total return refers to the sum of your principal and income, capital gains on your original investment, plus any income or capital gains on money you’ve earned on your original investment and have been able to reinvest. Total return is, very simply, the entire amount of money you end up with after a certain investment period, minus what you began with.