How Bonds Work
Stocks vs bonds differ in how easy it is to understand each one of them. Understanding how stocks work is a straight-forward process. To understand how bonds work, first we have to look at each of its components.
Face Value: this is the amount received if the bond is kept until its maturity date.
Maturity date: The date in which you will receive the bond’s face value plus the interest due in that date.
Coupon rate: the interest rate you will receive each year given its face value. For example, a bond with a face value of $10.000 and a 6% coupon rate will give you a total of $600 annually.
Yield to Maturity: It is the predicted rate of return the investor will get if the bond is kept until its maturity date.
Current Price: The current price of a bond. It is equal to face value when the bond is first issued (not applicable in zero-coupon bonds).
If an investor buys let’s say a bond with a face value of $10,000, a coupon rate of 6%, a maturity of 10 years and he keeps it until maturity, he will receive $600 annually plus the $10,000 in 10 years.
When it is issued, the coupon rate and the yield to maturity are equal (6%). However, as time goes by and depending on market conditions, the yield to maturity (YTM) can vary. Let’s say in the above example that the YTM goes down a few years after the investor bought it. In this case, the bond’s price would go up and the investor could sell it for a premium. If the YTM goes up, the bond’s price would go down.