How Bonds Work

A bond's principal, or face value, represents the amount of the original loan that is to be repaid on the bond's maturity date. The interest that the issuer agrees to pay each year is known as the coupon, a term derived from the obsolete practice of attaching coupons that could be redeemed for interest payments to the bottom of the bond certificate.

The interest rate, or coupon rate, multiplied by the principal of the bond provides the dollar amount of the coupon. For example, a bond with an 8 percent coupon rate and a principal of $1000 will pay annual interest of $80.

In the United States the usual practice is for the issuer to pay the coupon in two semiannual installments.

Bonds can be issued by a variety of institutions, including governments, municipalities and corporations. Many things, including market conditions, affect bond performance. However, interest rate sensitivity and credit quality tend to affect a bond’s behavior more than any other factors.

Interest rates and bond prices have an inverse relationship; when rates rise, bond prices fall and vice versa. Generally, longer term bonds are more sensitive to interest rates since there is more time for rates to change.

When interest rates fall, a bond issuer may choose to pay back the bond owner’s initial investment before the bond’s maturity date. They can then issue a new bond at a lower interest rate, but the original bond owner no longer receives regular interest payments. This is known as prepayment risk.