When you purchase a bond, you'll receive a series of interest payments and a lump payout when the bond matures. Current interest rates affect the purchase price of the bond, and changes in interest rates affects a bond's subsequent value.
Bonds Sold at Par
The current interest rate affects whether a bond is sold at par, at a discount, or at a premium. If a bond's interest rate is the same as the current market interest rate, it will be sold at par. Being sold at par means that the issue price of the bond - the price you pay to obtain it - is the same as the face value, which is the amount of money you'll receive when a bond matures. For example, say that you buy a $1,000 bond and the current market interest rate is 5 percent. If the bond also pays 5 percent interest, you'll receive regular interest payments and a $1,000 payment at maturity.
Bonds Sold at a Premium or a Discount
If a bond's interest rate is different than the current market rate of interest, the issue price won't be the same as the face value of the bond. If the interest rate is higher than the market rate, you'll pay a premium to buy the bond upfront. For example, you may be willing to pay more than the face value - maybe $1,100 instead of $1,000 - to lock in a higher interest rate of 7 percent instead of the market rate of 5 percent. Conversely, if the bond rate is less than the market rate, the bond will sell at a discount to compensate for the low interest payment.
Changes in Interest Rates and Interest Rate Risk
When you buy a bond, you lock in a series of interest payments at a certain rate. This means that, if market interest rates increase, the value of your bond decreases. This can be problematic if you want to resell your bond on a bond market before it matures. If the increase is dramatic, you may not even be able to resell your bond for what you originally bought it for. For example, say that you bought a $1,000 bond at par at a 4 percent interest rate, and interest rates increased to 7 percent. Now that bonds pay 3 percent more, it will be hard to find someone willing to buy your 4 percent bond. The risk that you'll have to sell your low-interest rate bond at a loss is is referred to as interest rate risk.
Handling Interest Rate Risk
In his Forbes.com article, investment analysis Mike Patton suggests a few strategies for handling changing interest rates. One way to minimize interest rate risk is to buy short-term bonds that take less time to mature. It's less painful to be stuck with a low-paying bond for five years than a low paying bond for 20 or 30 years. Another way to minimize risk is to hold the bond until maturity. As interest rates rise and fall, you'll still get the interest payment you agreed on and you'll receive the face value payment when the bond matures.