Whenever there’s market uncertainty, bonds get special attention. Investors want to protect their money from potential downturns. And whether the economy does well or not, bonds can make you money in both situations.
How do you know if a bond is profitable? The answer lies in a simpler question: What is the face value of a bond?
What’s the Face Value of a Bond?
When buying bonds, you’re lending money long-term while collecting interest every 6–12 months (at fixed rates). And while you can’t get back the principal until that time, you can sell this bond to another investor. For a profit.
Should you keep the bond and the interest, or should you sell it? It depends on the face value, AKA par value.
The face value is whatever principal you offer for the bond. Assuming you keep the bond until maturity, you’ll get back this face value plus the interest.
Knowing the face value, along with the market news, allows you to know whether you’ll profit or lose money. Here are three remarks:
- While face value doesn’t change, it’s different depending on when you buy. If you buy at $50 and someone else buys for $70, that’s two different par values.
- When new bond prices are below what you paid (below par), it suggests a higher investment risk. The company might be unable to repay.
- When new bond prices are above what you paid (above par), you can sell it for a profit, regardless of maturity. You keep all the interest accrued until then.
The Relation Between Face Value and Interest Rates
Let’s say you follow the simplest method. You buy a $1000 bond at 5% interest with 5 years of maturity. You expect to make $1250, being +$50 every year and $1000 in the end.
Why should you care about new bond prices/rates?
Well, why would a company raise the rates?
a. They’re making less money, which draws off investors. They raise the rates to compensate for the risk of defaulting
b. They’re selling long-term bonds (5+ years), which exposes the investor to more volatility. Higher rates compensate for the risk
c. Many investors believe that bond prices will go down. Maybe a credit company has labeled the company as “not recommended.” They raise the rates to attract more people
Thus, high-interest rates suggest that the company may default on your loan. For example, High Yield Investment Programs (HYIPs) may offer 10–20% of monthly interest, but they default so that you only get about 100%–130% yearly ROI (the average loan). AKA bait-and-switch scams.
What if you knew the company can’t pay back your loan? You could earn some interest and sell the bond while prices are high. In the case the company recovers, you could buy the bond back for cheaper and higher interest.
Face Value VS Price
These terms can confuse beginners, especially when they represent the same dollar amount. So what does the price have to do with face value?
If you’re a traditional investor (hold bonds until maturity), price is irrelevant. Whatever you pay for the bond becomes the face value. At maturity, you get back this same face value (along with interest), regardless of bond prices.
Now, let’s say the company issues new bonds with higher interest rates. Because it correlates to risk, you believe the company won’t pay back your loan. If you don’t want to lose your money, you can trade your bond.
Your choices are:
a. Hold until maturity and get back the face value of your bond, with a chance of defaulting
b. Sell your bond now based on the current prices
That’s where the price comes into play.
Why Do Bond Prices Change?
Why do prices fall when interest rates go up? For every bond investor, price changes have different meanings. Let’s see how it works with an example:
Initial condition: You buy a bond for $1000 (face value) at a 5% interest rate (AKA coupon rate) with 5 years for maturity.
Case A: Everything stays the same
You collect 5% every year and get the principal back on year five. A total of $1250.
Case B: The company is doing great
The business is growing and investors are confident. This allows the company to lower interest rates and keep getting new investors. Let’s say that in year three, bonds now offer 2.5% rates.
You still hold your 5% bond for the same price. If a new investor comes, what do you think he will want to buy? A $1000 bond yielding 2.5% or 5%?
Because of demand, your bond is worth up to $2000. You could sell right that day, and you still earned $150 after those three years. $2150 total.
If everyone holding 5% bonds decided not to sell, the price of 2.5% bonds may go up to $2,000.
However, if you hold until maturity, you’d only get $1250 ($250 in interest). There’s almost zero default risk.
Case C: The company generates lower revenue
Investors fear that the business may default on its loans. As the company needs more investors to recover, it offers higher interest rates for the risk. Let’s say 10%.
Suppose that you don’t like the risk and want to sell the bond, even at a loss. New investors have two offers:
- A 5% $1000 bond offered by you
- A 10% $1000 bond offered by the company
Given the risk and price, investors prefer 10% over 5%. The only way to sell your 5% offer is to lower the price. 5% bond for $500, for example.
If 5%-bond investors decide to hold, 10%-bond prices will be as low as $500.
Here are four possibilities:
a. Sell below face value and hope that the interest accrued helps you break even
b. Sell below face value at loss
c. Hold until maturity and hope that the company repays, at least partially to break even
d. Hold and hope that the company recovers, so you can sell at a profit
How to Manage Risk With Bonds
While bonds are “safer” than stocks, that doesn’t mean you can’t lose money. If you’re going to wait years for a return, you want to make sure the opportunity cost is worth it. Here are four factors to consider when deciding on an investment.
- Credit Ratings: Ranging from AAA to BBB- (most to least reliable), credit agencies (e.g., S&P500) rate how likely companies are to pay back. These ratings update every few months based on company updates, which affect market rates.
- Market rates: Besides the company performance, investors affect the bond price when trading them. You can check the market rates to find out whether most people are buying/selling, and use it in your favor.
- Time of maturity: Maturity is proportional to the risk and interest rate. 5–10-year bonds offer the best interest rates, while 1-year bonds offer the lowest ones.
- Inflation: Companies offer better rates to compensate for inflation risks. An inflated bond is unappealing to investors and is more likely to default. If you seek the lowest-risk investment, consider inflation-linked US Treasury Bonds.