A bond is the financial equivalent of an IOU. If you're purchasing a newly issued bond from a government or corporation, the par or face value is the amount of money you invested, usually $1,000 per bond, which the issuer promises to return to you at par value after a certain period of time, such as five years. During that time you will receive a stated rate of interest. Once you have purchased the bond from an issuer, its value will no longer be par value, but will be determined by the secondary market.
A bond's market value is the price at which you could sell the bond to another investor prior to the bond coming due. The time in the future that the bond is due is also known as expiration or maturity. The market value price is mainly determined by current interest rates and, in a normally functioning market, your bond will be worth a little bit less or a little bit more than par value prior to maturity.
How Bonds Trade
If you bought an investment grade bond from an issuer at par value in a low interest rate environment and rates are rising, your bond will be worth less than par to any potential buyer. This is because anyone buying it would need you to lower the price to make up for the higher interest rate they could now get on a newly issued bond. If you hold your bond until maturity, you will still get the par value, but if you need money today, you would have to take less than par value. The opposite is also true. If you invested in your bond when interest rates were high and they are now falling, it will be worth more than its par value. A buyer would have to make up for the higher interest you are now receiving by paying you more than par value for the bond. In other words, if you want to sell your bond which has a high rate of interest and interest rates today are lower, selling at par value would be a loss.
High yield or junk bonds are generally issued by companies or governments that have a low probability of paying the bond holder par value at maturity. Investors in junk bonds are taking a higher risk than investors in investment grade bonds. For this reason, junk bond investors demand a higher rate of interest. However, junk bonds are usually issued for shorter periods of time and market prices have much more to do with the improving or deteriorating prospects of the issuer. Hence, they tend to trade more like stocks.
Recession and Crisis
There's an old saying that "bad news is good for the bond market" that alludes to the fact that often bondholders are hoping for recession, because recessions tend to lower interest rates and make bonds more valuable. This is especially true in a financial crisis when no one trusts anyone but the U.S. government to hold their money. If you're already holding Treasury securities when a crisis hits, everyone wants to buy them and the price takes off.
- chart image by Kit Wai Chan from Fotolia.com