A bond is a financial contract between a buyer and an issuer -- typically a corporation or government entity. When you buy a bond, you're essentially loaning the issuer money in exchange for interest payments until the term of the loan ends. While there are countless types of bonds, from U.S. Treasury bonds to state-issued bonds to bonds issued by companies like Microsoft, they all share the same basic components.
The coupon rate of a bond is the amount of interest that is paid to investors. If you buy a bond with a 5 percent coupon rate, you'll earn $5 for every $100 you invest. Since most bonds are priced in units of $1,000, for every 5 percent bond you purchase, you'll typically earn $50 per year in interest.
Maturity Date and Value
The maturity date is the date that the bond pays off, or comes due. The value you receive at a bond's maturity date has nothing to do with what you paid for the bond. In most cases, maturity value, also known as par value, is $1,000. No matter whether you paid $900 or $1,200 for a bond with a par value of $1,000, you'll receive $1,000 at maturity.
If you buy a bond when it is first offered to the public, in a process known as an initial public offering, you agree to buy the bond at a stated price. After that, bonds trade freely in the marketplace. At any given time, a bond may trade at a price higher or lower than the IPO price. If you sell your bond before its maturity date, you might lose money.
Yield to Maturity
Yield to maturity is the total return you'll receive from the time you purchase your bond until it redeems at maturity. Yield to maturity is a calculation incorporating both a bond's coupon rate and the price differential between the maturity value and your purchase price. For example, if you buy a 6 percent bond at $1,000, your yield to maturity will be 6 percent, since the only return you'll earn will be your 6 percent coupon rate. However, if you only paid $900 for the same bond, you'll receive your 6 percent annual interest payments plus an additional $100 at maturity, resulting in a higher yield to maturity.
While not all bonds receive a rating, the majority of those that are sold to individual investors do. A rating represents the opinion of an outside agency about the financial reliability of the issuer. The higher the rating -- with AAA being the highest rating -- the less likely it is that the issuer will fail to make its promised payments. If you decide to purchase a lower-rated bond, you'll usually receive a higher interest rate because you're taking on additional risk.
Interest Rate Sensitivity
Bond pricing can be a complex process, but the essential thing for investors to remember is that as interest rates in the marketplace go up, bond prices go down. Imagine if you bought a bond paying 5 percent per year, which was the current market rate at the time of purchase. If the market rate rises to 10 percent five years down the road, the price of your 5 percent bond will fall, since new buyers will want to buy the 10 percent bond rather than your 5 percent bond. Generally, the longer your bond has until its maturity date, the more volatile its price will be. But if you hold your bond until it matures, you'll still receive the stated maturity value, even in a rising interest rate environment.
John Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to writing thousands of articles for various online publications, he has published five educational books for young adults.