Knowing how the price of your investment and its interest rate relates to one another can help you to make an informed financial decision regarding your investment.
Issuers don't like it when the interest rate on a bond rises and here is why: If you were to have a bond worth $2,000 at face value at an 8% rate of interest, that bond would make $160 in interest per year. If the interest rate were to increase to 10%, then the interest would be $200 per year. That is great for the investor if they buy the bond at this rate, but it may be difficult to find an issuer willing to pay on a bond 10% interest unless they had no other choice.
There are, however, times in which the face value of a bond and thus its average annual return will decrease to offset fluctuations in interest and this is not what an investor wants after they have bought a bond. For instance, you buy a bond at 8% interest for $1000. The interest rate then increases to 10%. In order for the 10% interest to be paid upon that bond, the face value drops to $800. In this case, a bond holder may want to hold the bond until maturity since market fluctuations can influence the face value and result in a loss if cashed out too early.
Now if the interest rate falls, the face value of the bond will go up. This is a good thing for the bond investor because this means that the bond is going to increase in face value while accumulating 6% interest. If you have a $1,000 bond when the interest rate is 8% and it drops to 6%, it is worth $1,333. If your bond matures during this period, you get the accrued interest along with the increased face value, which results in a much better profit than if you bought the bond at a 10% interest rate and it held steady there.
Overall, the face value fluctuates with the interest rate fluctuations. One tries to offset the other, but eventually, one is going to result in a much better profit, although interest will continue to accumulate based on the face value of the bond.
The amount of interest is based upon the price. For example, 8% of $1,000 is $80. If the rate drops to 6% and the value of the bond is $1333, then the return is $79.98. If the rate would go up to 10% and the face value of the bond would fall to $800, the return is still $80. It all comes down to accommodation and trying to ensure that the investor does not lose what they have invested. Basically, an individual is going to be making more money if the interest rates are low than what they would if it were high. If they invest high and it drops, then there is more power to the investor.
There is the fact, however, that most bond holders do not hold their bonds until they mature. They tend to cash them out early. When that's the case, the bond is not usually worth what it is projected to be worth. There is a projection for the maturity date of what the bond should be worth.
It's ideal to hold a bond until maturity so that you can get the most out of it. Some of the reasons why individuals cash out early are because they are anxious or they are fearful of a decline in the market and loosing face value on their bonds, but the markets always rebound.
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