As a bond approaches maturity, its price moves closer to its face value -- the contractual amount that will be repaid at maturity. If a bond is trading above face value, its price will come down; if it is trading below face value, its price will go up.
Bond Pricing and Trading
Bonds in the secondary market can trade for more or less than their face value – at a premium or discount. At maturity, an investor will get back the bond’s face value, regardless of how much he paid for it. As a bond approaches maturity, buyers are reluctant to pay a premium, knowing that they will get back less at maturity; sellers are equally reluctant to accept a discount, knowing that they will get back more at maturity. Bonds typically pay interest semiannually but trade with accrued interest: The buyer receives the next full payment but pays the seller the amount of interest accrued to him since the last payment. This allows for bond price adjustments on a daily basis.
When interest rates go up, bond prices go down and vice versa, because bond interest is fixed for the life of the bond. When interest rates change, new bonds are issued with a different coupon (nominal interest rate), so the existing bond prices must be adjusted accordingly. This adjustment disappears as a bond approaches maturity, because, regardless of the prevailing interest rate, an investor will receive the full face value of a matured bond.
When a bond is issued, it is rated by several credit rating agencies as to the issuer’s ability to repay. Lower-rated bonds have a higher risk of default and must pay a higher interest rate. After a bond is issued, a change in the issuer’s financial condition can trigger a ratings upgrade or downgrade. However, as a bond approaches maturity, the likelihood of default decreases, so once again the price reaches the face value by maturity, when the bond is repaid in full regardless of its credit rating.
If a default is imminent, bonds approaching maturity may not reach their face value. If an issuer does default, maturing bonds will trade based on how much investors expect to collect on them in bankruptcy liquidation, which, based on a bond’s collateral and seniority, could be anywhere from pennies on the dollar to almost the full face value.
- “The Wall Street Journal Guide to Understanding Money & Investing”, Kenneth M. Morris, 2004
- “PassTrak Series 7: General Securities Representative License Exam”; Dearborn Financial Services; 2003
Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.