A bond's current market value depends on its own interest rate, or coupon rate, along with its face value and the current market interest rate. There is a mathematical formula to calculate how much your bond is worth, but simply put, rising interest rates cause bond values to drop while falling interest rates cause bond values to rise.
The basics of bond pricing
When a bond is first issued, it is sold at a certain par value (also known as face value), which is typically $1,000 but other amounts are possible. It also has a stated interest rate known as the coupon rate, which is the amount of interest the bond pays as a percentage of its par value. For example, a bond with a par value of $1,000 and a coupon rate of 5% would pay $50 in interest per year.
How interest rates affect bond values
The market value of a bond depends on two factors -- the current market interest rate, and the bond's par value. In mathematical terms, the price of a bond is the sum of the present values of all of its future interest payments, plus its par value at maturity. If interest rates rise, the present value of future payments is less.
I'll spare you the complex formula used to calculate this, but here's an overview of how this works in practice:
For example, let's say that you buy a 30-year Treasury bond for $1,000 with a coupon rate of 4%, so it pays $40 per year. If the 30-year Treasury rate jumps to 5%, investors will now expect this yield from their Treasury bonds, or $50 per $1,000 invested. Since yours is only paying $40, the market value must fall in order to make your bond's yield more attractive to new investors. At a 5% interest rate, a bond that pays $40 per year would be worth $800.
However, keep in mind that the par value of the bond is $1,000, so an investor would get back considerably more than they pay upon maturity. This adds to the bond's yield to maturity and needs to be taken into consideration. In reality, a 30-year Treasury bond with a 4% coupon rate in a 5% rate environment would be worth about $845, with the extra $45 to compensate for the future profit expected from the bond's higher par value.
So, how much is your bond worth?
With all of that in mind, here's a quick calculator that can help you determine your bond's value or predict what it would be worth if interest rates were to change.
A couple of notes:
- "Desired yield to maturity" refers to the theoretical interest rate you'd like to evaluate. See my example below the calculator.
- If your bond is callable, it may affect the bond's value, based on the call date and market interest rate. In this case, the bond's yield to call needs to be considered as well.
For example, let's say that I own a bond with a $1,000 par value and a 5% coupon rate, with 12 years to maturity. We'll say that the current market interest rate for bonds with this maturity length is 4%. And I want to know what will happen to the value of my bond if the market interest rate spikes to 6%.
Well, based on today's market rate, my bond is worth $1,095, or $95 more than its par value. However, if the market rate were to rise to 6%, my bond's market value would drop to just $915.
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