Just like stock price, bond price is determined by supply and demand. When the demand rises, the price rises, and when everyone wants to sell the bonds, the price drops.
Assume that Ellen bought 10 Wal-Mart bonds with a par value of $1,000 each and bearing 20% annual interest. The bonds mature in two years. Ellen paid $10,000 US ($1,000 per certificate).
Ellen expects to receive these payments from Wal-Mart:
|
Time |
Principal |
Bond |
Reinvested Coupon Interest |
|
1 |
|
$2,000 |
|
|
2 |
$10,000 |
$2,000 |
$542 |
The principal is repaid only when the bonds mature, in this case after two years.
Assume that Ellen held the bonds for the first year and received $2,000 in interest from “Wal-Mart” at the end of the year (20%). Immediately after receiving this payment, Ellen needed cash and decided to sell the bonds. Unfortunately, times were hard, and she could get only $9,000 for the bonds. Ellen made a $1,000 profit that year: She paid $10,000 for the bonds, and received $2,000 interest, plus the $9,000 for which she sold the bonds at the end of the year. That means that Ellen made a 10% return on her investment (1,000/10,000).
David is the investor who bought Ellen’s bonds. He bought the bonds for $9,000, and will receive $12,000 at the end of the year: $10,000 in principal when the bond matures at the end of the second year, plus an additional $2,000 interest.
David bought the bonds for $9,000, and he will receive $12,000 at the end of the year. That includes $10,000 for the principal – the stock matures at the end of the second year – and an additional $2,000 interest.
David earns $3,000 on an investment of $9,000: This represents a 33% profit, which is far better than Ellen’s (10%).
