To understand this a brief introduction describing the difference between the price of a bond and the face value of a bond is necessary.
What do you mean by price of a bond?
Price of the bonds are not to be confused with its face value. The face value, or the par value, or the principal, as we may call it refers to the money a bond holder will get back on the maturity of the bond. The rate at which bonds are bought or sold is called the price of the bond.
Price of the bonds change on a daily basis and often fluctuates depending on a number of factors. Sometimes the price of the bond may be above the face value. Then it is said to be selling at a premium. When the bond sells at a rate lesser than the face value, it is called selling at discount. If a bond with a face value of $ 1000 is sold at $ 800, $ 800 is the price of the bond and here it can be said that it is being sold at a discount.
Price of bonds fluctuate with any change in market and economic conditions. An increase in the interest rates and economic policies have an impact on the price of the bonds.
It is not necessary to hold a bond until its maturity. The bond can be sold by the holder any time in the market. Sometimes he might sell at a rate higher than the face value or sometimes at a rate lower to it. Before getting to know how price of bonds changes and what kind of bonds have higher rate of price increase, it is important to know about the yield.
Getting to know about yield.
In simple words yield is nothing but the return you get on a bond. At face value, yield is equal to the interest rate. This can be explained with an example. A bond whose face value is $ 1000, will get an annual return at 10 %. Here, the yield is $ 100. So when the price of a bond falls to $ 800 yield is calculated with the formula, coupon amount or annual return/ price. In this case it is 100/800 multiplied by 100 which equals to 12.5 %. From this example it is evident that when price of the bonds fall, it causes the yield to go up. The same way, when the price of the bond goes up to $ 1100, yield is calculated by the same formula, coupon amount or annual return / price. In this case, 100/1100 multiplied by 100 which equals to 9%. This makes it clear that with an increase in the price of the bond yield comes down.
Thus, Price of the bond and its yield are inversely related.
Now let us see some of the bonds whose prices are seen to increase most commonly.
1.Â Â Â Floating rate bonds
These bonds have variable coupon (interest that is received periodically by the bond holder between time of its issue and its maturity.) Since this interest changes in floating rate bonds, their prices most commonly seem to increase. This is because, when the interest rate increases, there will be more buyers and the bond holder can sell the bonds at premium and make a gain. But in fixed interest bonds, always the interest remains the same, and when new bonds are issued at higher interest rates, there will be no takers for fixed interest bonds. So the bond holder is forced to sell them at discount and he may incur loss.
2.Â Â Â Cost indexed bonds
Conventional bonds pay fixed interest and principal. But the real values of future payments while issuing a conventional bond is unknown because of the uncertain nature of inflation. In case of cost indexed or inflation indexed bonds, the real value of payment to be received in future is known.
For example, a $10000 conventional one year bond is bought with a coupon rate of 5 %. After a year, the bond holder may receive $ 10500. Though the actual value of his return may be lesser if the inflation at this point is taken into consideration. Suppose the inflation had gone up by 3% than it was at the start of the year when the bond was issued. Something that cost him $10000, would now cost him $10300. So his gain is just a marginal $200. If the inflation is up by 5%, then the value of the bond would now have become $ 10500 and there is zero real return. In short if the inflation rises, the real return is negated and with a fall in inflation rate, the real return values at more than it was expected.Â In Inflation indexed bonds nominal return differs with inflation rate realized over the life of the bond.
3.Â Â Â Money market oriented bonds
In money market, which is a part of financial market, instruments with short maturity terms and high liquidity are traded. Because securities are of highly liquid nature, and have short maturity terms, money market is treated as a safe place. So money market is a place where short term securities like treasury bills, bankersâ€™ acceptances and commercial papers are traded.
4.Â Â Â Government bonds
When the government of any country issues a debt security for the sake of supporting government spending, it is called a government bond. Government bond is like a loan to a nationâ€™s government in its own currency. It is free of credit risk because the government raises taxes or prints more currency to repay the bond holders at the time of maturity.
The yield to maturity of a particular class of bond is represented by the yield curve. When there is still lot of time for the bond to mature, the yield will be more and the yield comes down as the bond approaches maturity date. Also, towards maturity date, the bond if it is trading at a rate lesser than the face value, will pick up and gain rise in price so that the price of the bond is close to par value.