The bond market always seems so confusing to almost everyone. It does look to be upside down. Why is it so?

When an investor buys a bond that matures in 20 years he plunks down his cash, say $10,000, and each quarter (or annually or as agreed) the bond issuer sends him a check for the interest. If it was 6% the bond holder will receive $600 annually until the twentieth year when the bond issuer returns his $10,000. Very simple.

But suppose the bond owner suddenly has a need for cash and must sell the bond. The bond issuer is not required to take back the bond until the 20th year. The investor must find someone to buy that bond now. Of course, the new owner will then receive the interest checks. The bond is still worth $10,000 at maturity so it should bring $10,000 on the open market. Or will it?

Not necessarily.

If the interest rate market has fallen to 3% for this type of bond then it should sell for an amount that will yield $600 on an amount of money at 3%. Now that bond is worth $20,000 ($600/.03X100). Conversely, if the interest rates have increased to 9% the amount received from the premature sale of the bond will fall to $666 ($600/.09X100). The bond holder gets less for the bond than the face amount, but the new owner will receive the full amount at maturity. The amount received from the sale is directly related to the current yield for bonds of the same quality.

As the interest (yield) goes up the principal amount the bond holder can realize from the sale of the bond goes down. As the yield drops the bond can be sold for more than the face amount, but will still bring the face amount at maturity. The amount of time to maturity is not being considered; however, the closer to maturity the more value the bond will have.

When an investor buys a bond he wants two things: safety of principal and return on his investment (ROI). There is no consideration for appreciation of capital. There are many types of bonds and they are rated in term of safety. The number one safety is the U.S. Treasury Bond. It is where almost every foreign government invests its money even beyond their own government securities. There are various rating agencies with the best known being Moody