Bonds are debt instruments issued by corporations and governments. In exchange for buying a bond, the bond issuer agrees to pay you a set interest rate until the bond matures. When it reaches its maturity date, the bond issuer pays you the principal amount of the bond. The principal is what you paid for the bond when you bought it. Since changing interest rates affect bond prices, if you sell the bond before it reaches its maturity date, the amount you receive may be different than what you originally paid. This amount depends on the direction of interest rate changes at the time of the sale.
Bond prices and interest rates have a contrary or inverse relationship. When interest rates increase, bond prices decrease and when interest rates decrease, bond prices increase. Investors refer to the interest rate effect on bonds as interest rate risk. The effect of interest rates on bond prices also depends on the maturity date. Long-term bonds expose investors to more interest rate risk than short-term bonds. This increased risk is because there are more fluctuations in interest rates over long periods than over short periods.
Credit risk is a measure of a corporation's ability to pay off its debts. The cost to borrow money increases when interest rates are on the rise. Rising interest rates increase the risk of a company defaulting on its debt obligations. Bond issuers compensate bondholders for credit risk by offering a higher coupon rate. A higher coupon rate means the bond issuer will pay you a higher amount of interest over the term of the bond. Credit risk due to increased interest rates is higher for long-term bonds then short-term bonds.
The face value on a bond is the amount printed on the bond coupon, so, if you buy a $1,000 bond, the face value is $1,000. The market value is what you receive if you sell the bond under current market conditions, before its maturity date. When interest rates increase, the face value of the bond doesn't change, but the market value does. This means you will have to sell your bonds at a discount and will receive less than the face value. In other words, you will receive less than what you paid for it. If you hold the bond until it matures, you will receive the entire face value of the bond when you redeem it, no matter what its market value is at the time.
When interest rates rise bond yields increase. You can calculate a bond's yield by dividing its coupon rate by the current price for the bond. Yields increase because when interest rates are high, investors sell bonds for less than face value or at a discount. When you buy a bond at a discount, you continue to receive the same amount of interest payments as the person who sold you the bond, even though you paid less for the bond than the seller did.
When interest rates rise new bond issue coupon rates generally reflect the higher interest. Simply put, the new bond issues are more valuable than the old bond issues. In this case, new bond issues are more attractive to investors because of their increased value over older bonds. If you decide to sell off your bonds after an interest rate increase, you will have to do so at a discount. Meaning, you will have to sell the bond for less than its face value.