Understanding Bonds Par Values Maturity Dates and Coupon Rates

So you just inherited some money from rich Aunt Penelope and you decide to invest some of it in bonds. You are afraid to though because you don’t know what all those different terms mean. Unless you are a seasoned investor terms like par values, coupon rates, maturity dates and others can be quite unsettling. Well just sit back, relax and in no time you’ll be using these terms like they were your middle name.

First I am going to assume that you know what bonds are and why they are important. When any company wants to borrow money it first determines how much to borrow. Let say ABC motors needs to borrow $10,000,000.00. It will sell bonds to raise the money. Now the keyword here is bonds because the company is not going to sell one bond for ten million dollars, rather it would sell the bonds in certain multiples. For example it may sell ten thousand units each with a par value of $1,000. That is what par value is simply the face value of the bond. Now it does not mean that you will pay the par value for the bond. To understand why an explanation of interest and our next word, coupon rates are in order.

When you buy bonds the company promises to pay you interest. The interest rate is stated on the bond itself and is simply known as the coupon rate. This term actually refers to a time when bonds came with coupons that you would detach and send to the company and they would send you the interest. Today most bonds don’t come with detachable paper coupons because the internet, online investing and bank wire transfers have largely taking its place. But I think you get the idea that coupon rate simply refers to the stated rate. Now when it comes to investing in bonds there is actually another rate that we need to discuss.

Interest rates are like anything else that is tied to the market that means they fluctuate. Obviously the coupon rate cannot change so some compensation must be made because the market rate helps to determine the fair value of the bond. Let’s use ABC motors to determine how this works. If you buy a $1,000 bond with a 10 percent rate and the market rate was 10 percent you would pay the same as the par value. This is because there is no difference between the rates. Now if the market rate was 9 percent but the coupon rate was 10 percent you would pay more for the bond. This is because the interest you receive will be greater than what the market or fair value is. This would make the bond more valuable and you would pay a premium for the bond.

What if the market rate was more than the coupon rate? Than you would purchase the bond for less than the par value because the interest you would receive is less than what the market or fair value is. This would make the bond less valuable and you would buy it at a discount. Before moving on to our next term there is another rate that is important to know.

Some bonds have what is called a zero coupon rate. Now this does not mean the bond does not pay interest. It simply means that the interest is paid all at one time rather than periodically. This means you will buy the bond at a discount and receive the full face value upon maturity.

Wouldn’t it be nice if ABC motors was a good company with a good bond rating and you could collect interest forever? Unfortunately it doesn’t work that way and this is where maturity dates come in. This is simply the date on which the company that sold (borrowed the money) the bond will pay the par value in full. There is one thing you should know about maturity dates. Some bonds are callable which means they can be paid before maturity dates. Other bonds are what are known as convertible which means the borrower has the right to convert the bond into preferred stock.

Well there you have it. I hope that I was able to give you a better understanding of some important bond terms and that you will be more comfortable when you are thinking about adding bonds to your portfolio.