Bond Face Value – What it is and How it Works
In general, face value is a term used to describe the dollar value of any security as provided by the issuer. In the case of stocks, face value is the same as the original stock cost as described on the certificate, but for bonds, face value is an amount paid to the bond investor when the bond matures. The amount is usually $1,000. Other names that refer to bond face value include par or par value.
If you are serious about investing in bonds, you should understand bond face value because it determines the amount you will receive at bond maturity. Also, bond face value affects the coupon payments and consequently, your interest in the long run.
To fill you in with everything about the bond face value, here is a quick guide.
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What is a bond face value?
You’ve often come across exerts comparing bonds to loans and debts right? This is because when you buy a bond, you are simply lending the issuer money to use on their policies or projects. In return, the issuer offers payments regularly (coupon payments) according to the bond agreement. Over time, the market value of the bonds you purchase change as interest rates fluctuate. This means that the market value of the bond at purchase is not always the same at bond maturity, but what doesn’t change with time and interest rate fluctuations is the bond face value. The amount you receive at maturity remains unchanged unless the issuer defaults on the payment.
For instance, if the interest rate is higher than the coupon rate, the bond will sell at a discount, but if the interest rate is lower in comparison to the coupon rates, the bond will sell at a premium price. Though the bond face value provides some form of guarantee on the return, the stock face value is not a good indicator of the real worth of the investment.
Bond face value vs stock face value
The investor receives the bond face value when the bond matures. At maturity, the bond might have profit based on the difference between the bond face value and the original issue price or extra interest rate.
Stock share face value represents the capital a company is required to keep up by the law. Only the amount above the set capital can be issued to investors in dividends. Generally, the stock share face value is like a company default reserve, but since there are no rules that dictate the face value of different businesses, business owners have the leeway to use low values as their stock share face value. For instance, AT&T face value is $1 for each common share, while that of Apple Inc. is $0.00001.
Market value vs. Face value
Bond face value or stock face value does not point to the real market value of the product. The principles of demand and supply determine the market value. These principles are governed by a dollar figure in which investors are more than willing to trade the particular security at. Depending on the prevailing market conditions, the market and face value have close to no correlation.
For bonds, you know the interest rates if the bond sells below or above the face value. For the zero-coupon bonds, apart from being associated with the bond face value, they are sold well below the face value to ensure you profit from the investment.
How Bond Par Value Works
Bonds are not always going at their face value. They can also come at a discount or a premium depending on the prevailing interest rates. A bond that trades above the face value trades at a premium, but one that is trading below the face value trades at a discount. When the interest rates have been low for some time, most of the bonds will trade at a premium, and when the interest rates are high, they will trade at discounts.
Premium and discount bonds
For instance, a bond that has a face value of say $1,000 and that is trading at $1,020 at the moment is said to be trading above par, at a premium, while if it were trading at $950 it will be considered a discount bond.
If you purchase a taxable bond for a price that’s above the face value, then the premium bond can be amortized for the rest of its life. This will offset the interest it receives from the bond and, therefore, reduces your taxable income from the bonds you invest in. Unfortunately, the same is not available for tax-free bonds bought at a premium.
Now, the coupon rate of the bond and the prevailing interest rates will collectively determine if the bond will trade at face value, below face value or above face value. Just so that we are on the same page, coupon rates are the amount you will regularly receive from the bond issuer until the bond matures. The payment can be annually, semiannually or even quarterly. The coupon rate is compensation for issuing the corporation, agency or government with the loan.
For instance, if you purchase a bond with a face value of $1,000 and a 4% coupon rate, then the annual coupon payments will be $40, but if the face value and the coupon rate are $100 and 5% respectively, the coupon payments will be $5. If you get a coupon bond at 4% and an interest rate of 4%, the bond will trade at face value since the coupon rate and interest rate are equal.
Bond face value and interest rate
If the interest rate was to rise to say 6%, then the bond market value will take a dip, and the bond will trade below its face value. This is mainly because the bond will pay you a low interest in comparison to the high 6% interest rate than other similar bonds are paying. As such, the price of a low coupon bond will not offer you a 6% yield.
If the interest rates were to dip to 3%, the bond’s market value would increase, and the bond would trade at face value. The reason is, a 5% coupon rate is attractive in comparison to a 3% coupon rate.
Now, regardless of whether the bond sells at a discount or a premium, the issuer will repay the bond face value upon bond maturity. So, if you purchase a bond at $950, and another on investor purchases the same bonds for $1,020, at maturity, you will both receive $1,000.
The face value of corporate bonds is stated either as $1000 or $100. Federal and Municipal bonds each have par values of $10,000 and $5,000 respectively.
Now that you understand what bond face value is, let’s get into the types of bonds.
The local, state or federal governments, agencies in the US governments and some US corporations issue bonds. There are multiple bond types, but the main ones include corporate bonds, municipal bonds and treasury bonds.
Bills, bonds and notes that the US government are called treasuries. They are usually the highest type of bonds you can get. The US Treasury issue bonds through the Bureau of Public Debt. All these securities are traded on secondary markets and are liquid. The bonds differ by their maturity dates. These dates vary from 30 days to 30 years. The main advantage of Treasuries is that they are exempt from local and state taxes. Also, the Treasuries have the full backing of the federal government, which means there is little risk the company will default.
- Treasury bills – these are short-term securities that mature in less than 12 months. They sell at a discount from the face value, and as such you do not receive interest until the bills mature.
- Treasury notes – these earn a fixed interest rate every six months. These notes mature anywhere between 1 and 10 years. A 10-year treasury note is the most common in discussions regarding the US government bond market performance. It also acts as the yardstick by the mortgage industry.
- Treasury bonds – Also known as T-bonds. Their maturities range from 10 to 30 years and like T-notes, they feature coupon payments twice in a year.
- Treasury inflation-Protected Securities – as their name suggests, they are protected from inflation. Their principal value changes with the Consumer Price Index and their maturities range from 5 to 20 years.
In addition to the Treasury Securities, some government agencies provide bonds as well. These include the Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae) and the Federal Home Loan Mortgage (Freddie Mac). These agencies offer bonds for varied reasons, but usually, the funds go to purchasing homes. The US government backs these agency bonds.
These bonds are by local and state governments. The funds go to help in building housing, highways, schools and sewer systems. The bonds are exempt from the federal tax and in some cases, from the local and state tax in your location. Municipal bonds have competitive rates, but they come with a risk of running the local government bankrupt.
There are two types of municipal bonds.
- General obligation bonds – the issuer secures and supports these bonds by their power to pay tax
- Revenue bonds – these are bonds repaid using the revenue that is generated by the project the bond funds funded
They issue a large fund to expand a business or to have a large capital investment. Corporate bonds have higher risks than government bonds, but they are associated with higher yields. The risk and value of corporate bonds depend on the reputation and financial outlook of the company issuing the bond.
Corporate bonds by companies that have low credit quality are known as high-yield bonds (junk bonds). If you choose to invest in a high-yield bond, then you should prepare for the different risks, rewards including high credit risk, more speculation, and high volatility.
A variation of the corporate bond includes the convertible bonds which allow you to convert the bond into stock under special circumstances.
This bond is also known as the accrual bond. If you invest in this bond, you will not receive coupon payments. However, you will purchase the bonds at a massive discount. You will redeem the bond for its full value when it matures.
The risk of investing in bonds
Before we start, we should point out that this list is in no way exhaustive. With that said, below are some of the main risks of investing in bonds, not that we are trying to scare you from investing in bonds, but it’s great that you understand the investment from both perspectives.
Credit risk is the possibility of not getting the principal or the bond interest after a specified time either because the issuer is unwilling to distribute the interest or doesn’t have the funds to offer. You can manage this risk by sorting the bonds into two groups; junk and investment-grade bonds. The highest investment-grade bond is AAA. In almost all cases, the AAA is the least likely to default. It is, therefore, the one with the lowest interest rate.
Like it or not, there is always a slight chance that the US government will put policies in place, either intentionally or unintentionally, that will cause inflation. Unless you have a variable bond or bonds with some form of protection, a high inflation rate will reduce your purchasing power and by the time you get back your principal, the price of basic goods will be significantly higher than they were initially.
Bonds are less liquid than stock. This means that the moment you purchase bonds, you’ll have a hard time selling them at face value. Because of this, we advise restricting your bond investments to bonds that you intend to have until their maturity.
For instance, if you bought bonds at $117 and they mature in 2027, you have two options, to wait until the bonds mature or to sell them before. If you sell them before maturity, you might get a bid request for $110. In which case the best option is to hold the bonds until maturity.
Believe it or not, such scenarios are more common than you would think. Bond investment experts refer to this as the bond spread and if you are not careful, the bond spread could hurt your investment. Because of this, make a point of purchasing large bonds since they fetch better bids.
When you purchase bonds, you expect the bond issuer to send you interest regularly. While this is a plus, the downside is that there is no way of predicting the rate at which you will reinvest your cash. If the interest rates have decreased, then you will yield lower returns for the money you reinvest.
Bonds have a lower risk in comparison to stocks. However, as seen above, they are not risk-free and while you cannot eliminate the risks, you can take steps to manage them. One of the best indicators of good bonds to invest in are bond ratings.
A bond rating is simple, a score that measures the financial strength of the bond issuer. There are three types of bond ratings. These include;
- Standard & Poor’s
Different agencies use a combination of letters, symbol and numbers to show the creditworthiness of the bond issuer. Fitch and Standard & Poor’s ratings rank bonds from the best to the worst as follows: AAA, AA, A, BB, BBB, B, CCC, CC, C, D. For Moody, the rating is as follows Aaa, Aa, A, Bbb, Bb, B, Caa, Ca, C.
From here, numbers and some symbols feature to give more specific ratings. Standard & Poor’s and Fitch use minus and plus signs to provide a hierarchy of creditworthiness. This means that a bond with an A+ is better than those with an A or an A- rating. Moody’s makes use of numbers to pass a similar point. In this case, Aa1 is better than an Aa rating.
Bonds with higher ratings are saver to invest in, but they have lower interest rates than those with lower ratings (it all boils down to the risk involved).
Bond-rating is not a foolproof method of deciding whether specific bonds are a good investment. Situations change with time, and a bond with a strong rating this year might not be as strong in the next.
How to Choose a Bond Broker
Though there are many ways to purchase bonds, you should consider purchasing through an agent or a bond broker. An agent will take you through bond investment basics, including bond face value and with time, turn you into a pro bond investor, but how do you choose a bond broker?
Below are some tips you can follow.
Do you even need a broker?
If you are buying treasury bonds, you do not need to go through a bond broker. You can complete the trade through Treasury Direct without incurring the cost of a markup. However, you should purchase corporate bonds and municipal bonds through intermediaries, but these cannot be bought directly from issuers.
Choose a broker that specializes in the bonds you want
Think of it this way; if you want heart surgery, there is no way you are going to a dermatologist. If you want to deal with individual bonds, then you are better off finding a broker who understands the ins and outs of that market. This increases your chances of landing a good deal.
Always be on your guard
After finding a broker and you agree on the trade, you should ensure that you will not pay a hefty markup. Even though ‘excessive’ is relative, you shouldn’t incur a cost that exceeds three months of interest.
Now the limitations of your dealer
The sad truth is that some dealers are not the best to build your entire investment portfolio. Some only understand bonds and while this might be a good thing for now, if you choose to invest in stocks later, go to someone else.
Bonds are a great way to diversify your investment portfolio. As you get started, familiarize yourself with all bond basics, including bond face value which doesn’t change over time. If the bond face value is $1,000, you will receive $1,000 at bond maturity.
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Who rates bonds?They are rated by third-party institutions that use different types of ratings. The best bond rating is AAA or Aaa depending on the style of rating you choose.
Does the bond face value change with the interest rate?No, it doesn’t. Changes in the interest rate affect market value.
Is bond face value always $1,000?The bond face value remains the same over the years. Though most issuers set the bond face value at $1,000, this is not the fixed face value. Some come with $100 face value. But whichever the value, it remains the same until maturity.