Just call us Bond. Amortized bond.
Over 700 finance terms, Shmooped to perfection.
We all know how this one feels on the course, but that's not what we're going for here.
When you buy a bond, it has a face value: that's the set price of the bond when it was issued. That bond will pay out a certain coupon or amount each year, no matter what, as long as the company is around and able to pay its bills. So far, so good. You can make money by just holding onto that bond and getting your money each year.
But sometimes, the actual trading value of the bond goes up because investors are willing to pay more than the face value. Why would they do that? Well, if interest rates have dropped, then bonds being sold today may have smaller coupons, so investors stand to make less per year. Someone who wants to invest today might be willing to pay for your bond (which has a higher interest rate). When this happens, your bond is selling above par.
Sell your bond above par, and you'll make a quick buck.
Let's say the Galactic Empire incorporates and decides to issue bonds because they're in debt after building a new space station. Darth Vader decides he wants to buy a $1,000 bond. He's getting up there in years and wants to be able to enjoy his days in retirement at some point. He gets himself a 5-year bond with a 10% coupon. That means that every year, he'll get $100 for handing over his cash, and at the end of five years, he’ll get his original $1,000 back.
After two years, Darth is dreaming about what he'll do with that money if there's a disturbance in the Force. Interest rates drop. Now the same type of bond from the Empire comes with a 6% coupon because of the change. Good ol' Darth is feeling pretty smug because his bond is locked in, but what happens to anyone who wants to invest now? Well, they can accept the lower coupon (which means they'll make only $60 a year on the same $1,000 investment) or they can buy an older bond with better rates—the kind of bond Darth has. Darth Vader's bond is selling above par, meaning it's selling higher than its face value. Investors may be willing to spend $1,170 or so for Darth's bond.
Should Darth sell? After two years, he's collected $200 in coupons and invested $1,000. If he sells for $1,170, he'll have made $370 from his investment ($200 from the bond and $170 from the sale) and he'll get his $1000 back. If he were to hang on for the full five years, he'd make $500 ($100 a year for five years). Is it worth it for him to get $370 back now? Maybe... if he needs new boots now.