Bond yields ...
Paid more than £100? The return (your yield) will be less than the coupon
So you're asking: why would I buy a bond that has a face value of £100 for more than £100, say £105?
You'd make a £5 capital loss when Bondco pays you back £100 right?
Yes, that's true but this goes to the heart of why investors buy bonds.
The primary purpose of a bond is to provide a known stream of cash flows. Bonds are about income - you have to understand a bond's yield at the time you buy it.
Let's suppose Bondco sold the bond for £100 in its IPO but there was enormous demand. Many investors didn't get any allocation of bonds. Lots of investors start trying to buy the bonds in the secondary market.
The price goes up.
In effect, some investors are saying that they just want the bonds and they are prepared to pay more than the face value.
As the price of the bonds goes up, the yield (the return) falls. If the price immediately increases jumps to £105, the yield falls to 3.2%.
New investors are prepared to accept a 3.2% yield on Bondco's bonds.
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