Many factors affect bond prices including the market interest rate, the remaining years to maturity, the amount of coupon payments and the frequency of the coupon payments. Bonds normally pay coupon interest semiannually. But assume a bond makes coupon payments annually, and if all else is held equal, such a change in the frequency of coupon payments may increase or decrease the bond price, depending on the relative market interest rate to the coupon rate.
General Bond Prices
Bond prices change in response to changing market interest rates. When the market interest rate that a bond’s investors require is higher than what the bond pays in coupon interest, the bond must sell at a discount to its face value to attract potential bond investors. On the other hand, when the market interest rate that a bond’s investors accept is lower than what the bond pays in coupon interest, the bond may sell at a premium to its face value to compensate current bond holders. The relative level of a bond’s market interest rate and its coupon rate affects bond prices differently when comparing prices of bonds with different payment frequencies.
Payment frequency mainly affects interest compounding. The more frequent a bond pays its coupon payments, the higher the effective yield of the bond under the same annual coupon rate. If a bond pays coupon interest semiannually instead of annually, it will compound interest twice rather than once, increasing total bond returns at the end of a year. Part of the bond return is also a reflection of the price paid at purchase. Depending on market interest rates, bond prices can be lower or higher as a result of payment frequencies.
A bond with annual payments would have a higher price than a bond with semiannual payments when they both are selling at a discount. In other words, bond yield on the semiannual payment bond is higher than that on the annual payment bond. However, regardless of payment frequency, bond investors receive the same total amount of cash payments at maturity. Therefore, the semiannual bond with a higher bond yield can achieve the expected level of yield only through a lower purchase price.
A bond with semiannual payments would have a higher price than a bond with annual payments when they both are selling at a premium. Bonds can sell at a premium only when their market interest rates are lower than the coupon rate. In general, bonds with semiannual payments are more sensitive to changes in market interest rates. For the same amount of decline in market interest rates, bonds with semiannual payments tend to see more price increases.