How corporate bonds work

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Yield

Because a corporate bond price changes as it trades on the market, the yield of the bond depends on the actual price, not the face value. When a bond is selling at more than the face value (selling "at a premium") the yield is lower because the coupon rate is fixed, but you are paying more for the bond. The same is true if the bond's price falls below the face value (it's trading at a discount). The coupon rate stays the same, but since you pay less for the bond, the percentage yield is greater. For example, suppose a corporate bond has a coupon rate of $80 and a face value of $1000. The coupon rate is therefore 8.0 percent. If the bond's price falls to 75 percent of the face value (a market price of $750), you get the same $80 coupon rate. Your yield is $80 divided by $750, or 10.67 percent.

Market Influences

The most important influence on bond prices is the prevailing interest rate. If interest rates rise for any reason (Federal Reserve policy or inflation, for instance) a bond's yield becomes less attractive. The price will fall until the yield has risen to match the new interest rates. If interest rates fall, bond yields become more attractive, increasing investor demand and driving prices up until the yield again matches the new rates.

Credit Risk

The other major factor affecting the price and yield of corporate bonds is risk. Corporate bonds, especially high-quality "blue chip" bonds, are considered safe investments, but they are not without risk. Corporate bonds are rated according to the creditworthiness of the company that issues them by independent ratings services like Moody's (see link below under Resources). Top rated (AAA) bonds are considered the safest. These bonds tend to have somewhat lower yields because investors are willing to pay more for a lower-risk bond. If a company's rating goes down, the bond price will fall, increasing the yield to offset the increased risk. So-called "junk bonds" are rated as high-risk. They have higher yields, but investors

are less likely to get their money back when the bond matures.

Resources

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Source: ehow.com

Category: Bank

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