Bondco's bond trades up from £100 to £102
What happens to your return?
The change in price of your bond has no impact on the income you expect to earn if you intend to hold the bond to maturity.
You will still receive 5% interest each year and you still expect to get £100 back at maturity.
Your expected return is 5% on a hold-to-maturity basis.
Of course, you could sell the bond.
Let's suppose you sell the bond on the first interest payment date for £102. Your total income from the investment will comprise of £5 interest and a £2 capital gain.
Click here for more detail
But Bond prices move.
Should you care?
That depends on whether you must sell. Many investors don't need to sell and so they don't worry that a bond has gone down in price because they take the view that the company will pay them back. It's like holding equity: prices go up and down. You have to make a call. If you need the cash, you may need to sell at a loss (or a gain!)
If you sell a bond below the price you paid for it, you'll make a capital loss. But whatever the price, the interest payable is always the same - whether you paid £80, £100, or £120. Let's look at yields now.
Bond yields?
Not the same as interest!
The interest rate is also known as the coupon. Here, we have a 5% interest rate (a 5% coupon).
The yield is something different.
To keep things simple, if you buy Bondco's bond at £100 and hold it to maturity, your yield will be 5%. The yield is the same as the coupon because you paid £100 and received back £100.
Suppose the bond was offered to you for £80. Intuitively, you know you will make more money because you pay £80 and get back £100. Your "yield" has gone up. The yield on a bond therefore depends on the price you pay for it. If you pay more than £100, then your yield will be below 5%.
PRICE LESS THAN PAR? > > > YIELD MORE THAN COUPON
PRICE MORE THAN PAR? > > > YIELD LESS THAN COUPON