The most basic concept that the investors need to get familiar is the pricing of the bonds. The bonds aren’t traded like stocks. When you purchase a bond, the one is making a loan to issuing company or government, therefore bonds are the loans.
Each bond got a par value and can be traded at par, at discount, etc. The interest paid for the bond is fixed but not the yield as the interest is relative to the current price of the bond which fluctuates continuously. These bonds fluctuate on the open market with the response to supply and demand for it. Its price is determined by discounting the expected cash flow to present one in using the discount rate. The three primary influencers of the pricing are supply and demand, the age to maturity and credit ratings.
Bonds are issued with a face value and trade at par when the current price and the face value is equal. Bonds that are at a premium are usually traded at the time when the price is much more than the face value. For example, a $ 10 face value bond sold at $15 is trading at a premium. Bonds that have low prices usually have higher yield hence they look more attractive to the traders.
For example, a $100 face value that has a 6 percent interest rate pays $6 in an annual interest per year regardless of the trading price. Interest payments are fixed. When the bond is trading at $75, That $6 interest payment creates a yield of 7.5% since the one would rather pay $ 75 to earn $6 than pay $100 to earn that same $6, bonds with high yields are better to buy than the lower one.
The age of the bond is relative to its maturity and this fact effectively affects the pricing of the bond. Bonds are paid at the face value when they mature, though there is an option to redeem, call, etc before maturity. Age and demand for bonds influence prices, and ratings provided to bonds and their issuers also have a large impact. Since the bondholders are less likely to purchase bonds with poor ratings, the prices of those types of bonds are likely to fall.
Investors look forward to considering how the approach of a maturity date will be affected by the price. They also should be aware of the effect that a call feature on the bond. Callable bonds can redeem prior to the date of maturity at the issuer’s discretion. Due to the possibility of the early redemption, if the interest rates have gone down then the price of the bond will approach to maturity. This type of situation makes it more appealing to the issuer to redeem the bond early. But if the interest rate has shoot up, then an approach call date won’t be affected by the price, as the issue is less likely to get to the option to call the bond.