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What is a bond?

A bond is evidence of debt. What this means is that, in basic terms, a bondholder is a lender. The bondholder loans money to a corporation or government or its agencies. For this loan, the debtor pays interest. Simple concept, tried and true. How does this relate to fluctuations in interest and market rates?

When the market fluctuates, so do the prices of bonds. However, different from equity investments such as stocks, there is an inverse relationship. When market rates rise, the price of bonds goes down, and when the market falls, the prices of bonds rises. Why this happens is a very simple concept. Bonds are considered safer than stocks, on the whole. They have a higher claim to assets when a company dissolves. Because of this fact, bonds are more valuable to an investor in times of falling interest rates. They are considered more secure.

The par value of most bonds is $1000. Each bond has a stated rate of interest at the initial sale to the public. Say for instance you purchase a bond at par with a stated rate of 7%. This equals $70 of interest annually. A year later, market rates have fallen drastically. People flock to buy these 7% bonds because nothing else on the market is earning that much. The demand for these bonds drives the market price up, making the bond trade at somewhere around $1200. In order to compensate for this higher price the bond is currently trading for, also referred to as "selling at a premium", the actual rate of return falls to compensate for this price difference from par. You see, the bondholders are still earning just $70 of interest a year for the bond, yet they have paid more for it, making their actual rate of return less than the stated. The same is true for rising markets. The bonds will sell at a "discount", making the actual yield on their investment more than the stated rate of return. The interest rates have adjusted to current market rates while the price has inversely changed to compensate.

Although this is a very simple concept to understand, it is one often left unexplained in simple terms. It makes bonds a unique investment, and one worth looking into further.

Learn more about this author, Bella Grant.
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