Investment Bond Function

• Bond securities typically pay an investor a set rate of interest each year, and the face, or principal, amount of the bond is paid off on the maturity date. The price an investor pays for a bond may be higher or lower than the face amount, based on the rate the bond pays -- known as the coupon rate -- compared to the prevailing rate for similar bonds. An investor can sell a bond at any time in the secondary market. The price received also will be based on prevailing rates compared to the coupon rate paid by the bond plus the time remaining until the bond matures.
  
  

Bond Interest Rates

• The interest rates for bonds of different maturities is called the yield curve. In a normal yield curve, rates get higher as maturities lengthen. The conventional definition of short-term bonds is maturities of one to three years. Long-term bonds have maturities of greater than 10 years. With a normal yield curve, investors earn higher rates in exchange for tying money up for a longer period with long-term bonds. For example, in May 2011, the interest rate on a two-year U.S. Treasury bond was 0.625 percent, and the 30-year Treasury bond was paying 4.375 percent.
  
  

Bond Prices

• An individual bond pays a fixed amount of interest to an investor. To adjust for changing rates the market value or price of a bond will change. An inverse relationship exists between bond prices and interest rates. If rates increase, bond prices decline, and falling interest rates result in higher bond prices. Short-term bond prices are less affected by changing interest rates. A short-term bond will mature relatively quickly, and the proceeds can be reinvested at current rates. Long-term bond prices will change significantly as a result of changing interest rates.
  
  

Bond Price Changes

• As an example, consider the comparison between a two-year bond and a 20-year bond. Assume the two-year bond has a current yield of 2 percent. If rates rise by 0.50 percent, the market price of the two-year bond will decline by less than 1 percent. Assume the 20-year bond has a current yield of 4 percent. If rates for this maturity rise by 0.50 percent to 4.5 percent, the market value of the bond will decline by 6.5 percent.
  
  

Investor Considerations

• Investors buy short-term bonds for price stability in exchange for lower rates. Short-term bonds are the appropriate choice when interest rates are rising. Long-term bonds give a higher yield in exchange for higher price volatility. Long-term bonds can provide capital gains profits if interest rates decrease.