A bond is a debt security, or IOU, issued by a corporation or government agency in exchange for the money you lend it. In most instances, bond issuers agree to repay their loans by a specific date, and to make regular interest payments to you until that date. The interest rate, called a “coupon,” does not change. That’s why bonds are often referred to as “fixed-income” investments. The end date that the issuer has to pay you your principal is called the maturity date.

Even though a bond’s interest rate and maturity date are fixed, the price at which you can sell a bond on the secondary market, before its maturity date, is not fixed. That’s because the economic environment in which bonds are bought and sold is never fixed. In particular, as the Federal Reserve Bank tries to dampen inflation or spur growth by changing federal interest rates, the demand for bonds, and their selling price goes up or down.
Imagine, for example, that you bought $10,000 worth of a ten-year bond that pays a 6 percent coupon. Now, suddenly, the Fed raises interest rates to 8 percent. Understandably, you might want to sell your bond and buy one with the higher interest rate. Trouble is, who in their right mind would want to buy your bond at the price you paid for it—par, or $10,000?—when the coupon is only 6 percent? No one, since anyone who wants a bond can go out and buy a new one and get an 8 percent coupon. So, in order to sell your bond, you would have to lower the price. Think about it. If the selling price for your bond were lowered to about $8,000 and the person who bought your bond would be getting $600 a year (6 percent of the $10,000 face value of the bond), then, at the $8,000 price, the bond’s yieldwould rise to 7.5 percent. Someone might think about buying it at that price especially because, when the bond matures, it will pay him or her the face value, or $10,000. So not only would the buyer be getting a good current yield. but his yield to maturity would be so good that it would make this bond competitive with the new bonds paying higher interest rates.

For more information on bonds visit: TreasuryDirect