The price of a bond depends on a number of factors, including its interest rate, time until maturity, safety rating and the prevailing market interest rate, which is the rate lenders are currently demanding for bonds of a given maturity and rating. The effect of differing payment periods depends on prevailing rates.
Markets quote bond prices on a percentage basis. For example, a bond quoted at 103.75 is selling at a 3.75 percent premium above its face value, also called its par value, which is the amount you’ll receive at maturity. A bond quoted at this price with a $1,000 face value sells for $1,037.50. This is its “clean” price, which doesn’t include accrued interest. Most bonds pay interest semi-annually, so on each payment date, investors in these bonds receive half of the year’s interest. The price of a bond should equal its present value, which is the sum of the bond cash flows discounted at the prevailing interest rate, although other factors might influence the bond's price.
When you buy a bond, you pay the seller the interest that’s accrued since the last payment date. In return for paying the accrued interest to the seller, you receive the full interest amount when next paid. The net result is that you earn interest only from the day you bought the bond. A bond with annual payments accrues twice as much interest as its semi-annual twin, but pays it half as often. Therefore, the so-called “dirty price” of an annual bond exceeds that of a similar semiannual bond as of the seventh month following the previous payment.
You can reinvest a bond’s interest payment at the prevailing market rate. “Compounding” is reinvesting interest to earn more interest. A semiannual bond compounds twice as much as an annual bond. If prevailing rates are lower than the bond’s interest rate, an annual bond will have a higher price than its semiannual twin, because bond investors are willing to pay more for the extra six months of relatively high accrued interest. The inability to reinvest interest at the original rate is called reinvestment risk, and semiannual bonds have more of it than annual bonds. If prevailing interest rates are higher than the bond’s interest rate, investors will prefer the semiannual version of the bond since they can begin earning compound interest at the higher market rate six months sooner.
Bond prices fall as interest rates rise because investors become disenchanted with the lower interest paid by older bonds. All things being equal, rising rates erode semiannual bonds prices less than they do annual bonds because of the compounding effect. Conversely, lower prevailing interest rates boost bond prices, as buyers chase bonds paying comparatively heroic rates. In this situation, the shorter accrual periods of semiannual bonds work against the bond’s rising price.
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