A bond is an IOU between the issuer and the investors. An option free (straight line) bond is a simple form of bond. Straight bonds pay fixed periodic coupon (annual or semi-annual) over the life and return the principal on maturity date. For example, a bond issued by the Treasury for a par value of, say $1000, with a maturity period of five with an annual interest rate of six per cent on maturity value. In such a case, the issuer, in this case – the Treasury pays an annual interest of $60 for five years, till the bond attains a par value of $1,000 and the Treasury redeems the bond to the buyer at a value of $1000 after five years from date of issue.
Bonds can be classified as: premium bonds, par bonds, and discount bonds.
- For a premium bond, price exceeds its face value. The market interest rate is less than the coupon rate. At maturity the price of a bond must equal its par value. For a premium bond, price must fall over its life.
- For a par bond, price equals its face value. The market interest rate is equal to the coupon rate. The price of a par bond may remain the same over time.
- For a discount bond, price is below its face value. The market interest rate is greater than the coupon rate. Price must rise to reach par value at maturity.
Remember that the price and yield of a bond are inversely related to each other. When yield increases, the price decreases and vice versa.