Bonds represent money borrowed by a corporation or government. The borrowed money must be repaid when the bond matures. The approach of a bond’s maturity date may cause the price of a bond to increase, but it can also have the opposite effect. Whether the current price goes up or down as it approaches maturity depends on how that price compares with the bond’s par value.
At any given time the price of a bond can be more or less than the par value. Par is the amount the bond issuer pays at maturity to retire the bond debt -- it is, in effect, the original principal on the loan that a bond represents. If a bond price is greater than the par value, the bond is said to be at a premium. The bond is likely trading at this higher premium price because the coupon rate -- the interest rate it pays on the par value -- is higher than the current market interest rate. If the price is less than par, the bond is selling at a discount. This occurs because the bond's interest rate is lower than the market rate. Normally, current market interest rates have the greatest effect on bond prices, although other factors, principally the issuer’s credit rating, may also have an impact on bond prices.
When a bond is paid off, or redeemed, at maturity, the bond issuer pays the bond's owner the par value. Consequently, as the bond nears maturity, the price moves close to the par value. Why this occurs is pretty simple. A bond owner won’t sell the bond at a discount price when she will soon receive the higher par value amount, so potential buyers have to pay more. Buyers won’t pay much of a premium price for a bond nearing maturity because they will receive only the par value when the bond is redeemed.
The approach of a maturity date has less impact on bond prices for short-term bonds. The reason is that a bond with a short life tends to stay closer to the par value throughout its life than a long-term bond. Suppose a company issues a bond with a 30-year maturity. Chances are interest rates, and consequently bond prices, will vary quite a bit for most of that time. At the other extreme, the price of a bond with a maturity of a few months usually stays close to the par value because interest rates usually don’t change a whole lot in such a short time. Plus, the bond will be paid off in a short time in any event.
Investors who are concerned about the impact of an approaching maturity date on the price of a bond also need to consider what may happen if the bond has a call feature. Callable bonds may be redeemed early at the issuer’s discretion, either on or anytime after a specified call date. When interest rates have fallen, the bond will normally sell at a premium. The issuer can exercise the call option, redeem the bonds and issue new bonds at a lower interest rate. In essence, investors face the possibility of an early redemption, so the bond price behaves as if the bond were approaching maturity. The bond is probably at a premium price, which is likely to fall as the call date approaches. On the other hand, if interest rates have gone up, the approach of a call date has little effect on price because the issuer won’t get lower interest rates by redeeming and reissuing the bonds.