Bonds are a financial entity that a buyer purchases and lends to the owner of the bond. It is a debt that is given to the holder. The issuer can be anybody, from a private organization to government organization. There is a difference between bondholders and stockholders. Bondholders are not a part of anything in the company. They are merely lenders. When a company becomes insolvent, the bondholders get their money back somehow, whereas stockholders incur a loss.
The way a bond interest is calculated is also different from a stock calculation. When we buy a bond, say for Rs.10000 at 7% interest for 10 years, we will keep receiving an interest of Rs.700 a year for a period of 10 years. So, at the termination of that time, we will get the original invested amount or the face value.
Now, there are people who buy new bonds that have been issued and some who buy bonds that are already with the investors in the market.
Bonds that have just got issued are the bonds where interest rates come to play. Here, when a bond is bought, it continues to pay up the same interest amount to the buyer regardless of the market rates. But, if you purchase a bond that is in the open market, the market interest rate is set, but market rates keep fluctuating. So, in order to sell your bond before maturity you will have to match the price of the bond with the market rate to make it attractive.
Now, suppose you purchase a bond for Rs.10000 at 5% interest for 10 years. The market rate of interest is 6% and the bond has to be sold before maturity. So, the bond value will have to be reduced to such that it matches the market value and appears attractive to the other buyers. Say, we reduce the price to Rs.8333. Then, the bond will pay the Rs.500 at 6% interest. By this market rate is met and the bond is saleable in the market.
So, by altering the price of the bond, the same face value will be achieved at the termination of the time period.
Now, if the market rate falls when the bond is issued, then the bond will be sold at a premium. There are factors that count if the bond rates increase. Firstly, if we have a bond and we hold it till maturity, and meanwhile, the market interest rates fall, then nothing will happen. We will get the same face value, no change.
Secondly, if we have to sell the bond before maturity, the rate of sale will be calculated at the market interest rates. If the interest has fallen, then the bond will be saleable at a premium and if the interest rates in the market have risen, then the bond will be at a lower price.