Bonds are an IOU or debt by the issuer to the bondholder.

When you invest in new bonds you are lending money to the issuer, whether that is a private company, a local or state governmental unit or, in the case of Treasury Bonds and Bills, the U.S. government.

Bondholders do not own a piece of the company, so they don’t get to vote on matters before the company.

However, bondholders are ahead of stockholders in payment when a company goes bankrupt. Stockholders typically lose everything when the company files for bankruptcy, while bondholders may receive some portion of their capital back.

### Bond Different

Bonds are also different than stocks in how the value is calculated.

Most bonds pay a fixed interest rate for a fixed number of years and then repay the face value of the bond to the owner.

For example, if you bought a $10,000, 10-year bond that paid 5 percent interest you would receive interest payments of $500 per year for 10 years. At the end of the 10 years, the bond would return your investment – in this case, $10,000.

Some people buy newly-issued bonds from the issuer, while other buy bonds from other investors.

### Newly-Issued Bonds

If you buy a newly-issued bond, you will receive the same interest payment every year until the bond matured regardless of what market interest rates do.

For example, a 10-year bond paying 5 percent interest will continues to make the same interest payment for the full 10 years.

However, if you buy a bond on the open or secondary market, a different set of circumstances comes into play.

For example, if you own a 10-year bond that pays 5 percent interest and want to sell it before its maturity, you must adjust the price to match current market rates.

If the current market rate is 6 percent, why would anyone want to buy your bond that only pays 5 percent?

Obviously, no one would. However, the market has a way of making adjustments so a bond paying 5 percent is as attractive as a bond paying 6 percent.

The interest rate is fixed and can’t be changes, so the only way to make you bond attractive to a potential buyer is to lower the price.

### Bond Example

For example, if you have a 10-year bond paying 5 percent with a face value of $10,000, you would have to reduce the purchase price from $10,000 to a number that would equal the current 6 percent return.

Here’s how it works. You lower the price of your bond enough to make the 5 percent payment equal a 6 percent payment of the full amount.

When the bond matures, the new owner will receive the full face value - $10,000. Here’s an example:

If you own a bond paying 5 percent and the market rate is 6 percent, how much will you have to discount the face value ($10,000) so the fixed interest payment of $500 (5 percent of $10,000) is equal to the current market value of 6 percent?

The annual payment of $500 ($10,000 x 5%) must equal a 6% payment. Doing the math (5% divided by 6% = 0.8333), you discover that the face value of the bond must be discounted to $8,333 so that the $500 fixed payment equals a 6% yield on the buyer’s investment ($8,333 x 6% = $500).

If you bought the $10,000 face value bond paying 5% for $8,333, it would pay you $500 per year in interest, which is the equivalent of earning 6%.

### Full Face Value

When the bond matures, you will receive the full $10,000 face value.

It is worth noting that if market interest rates have fallen since the bond was issued, the bond will sell at a premium (more than face value).

This is a simple example that does not take into account many factors such as brokers fees, potential tax consequence and so on.

There is a more sophisticated calculation that experienced bond brokers can perform that gets closer to your true yield if you hold the bond to maturity.

This is a long answer to the question about what happens to bonds if interest rates rise – as many expect will happen.

The short answer is in two parts:

First, if you hold the bond to maturity, nothing happens to the bond’s interest rate. You will receive the same annual payment.

Secondly, if you want to sell or buy a bond in the secondary market, the price will be calculated based on existing interest rates. If rates have risen, the bond will sell at a discount. If interest rates have fallen, the bond will sell at a premium.