There are two types of interest rates associated with bonds: coupon rates and yield to maturity. Coupon rates are the stated borrowing rates associated with a particular bond issuance, and can be seen as a direct cost of borrowing money. However, investors also focus on market-based bond rates, which are measures of risk associated with the borrower's creditworthiness. Because of the mathematics underlying bond pricing, if the perceived creditworthiness of a borrower changes, the price of the bond can change, even though the coupon rate remains unchanged.
Risk and Return
A bond's value is equal to the sum of the present value of its future interest payments and the repayment of principal. Bonds typically are issued at a par value, usually in multiples of $1,000. If the bond's coupon rate is equal to its yield to maturity, the bond's market value is equal to its par value. If the yield to maturity is higher than the coupon rate, the bond trades at a discount to par. This is because of the opportunity cost associated with holding a bond investment that pays interest at a rate that is lower than what can be received from similar issuers on the open market. Driving these yields are investor perceptions of a variety of risks, including credit risk, default risk, liquidity risk, interest rate risk and market risks. Duration is good measure of interest rate risk, which is the expected change in a bond's price stemming from shifts in interest rates.
If news is released that indicates that a borrower's financial position has fundamentally improved, this increases demand for the bond, causing the price to increase and the YTM to decrease. Interest rate is a measure of risk, and the increased demand driving the bond price upward implies less risk is associated with that particular bond investment. Look at YTM as the rate of return required to entice investors to invest in a particular bond, given the risks inherent to that investment. The greater the risk, the higher the YTM.
These price fluctuations primarily impact publicly traded debt, but private company debt is affected by the overall level of interest rates, even if its debt is not subject to volatile price movements. Also, even with publicly traded debt, you can eliminate horizon risk, which is the danger that the ultimate return on the bond investment will vary from your initial expectation. This is because if you buy and hold the bond until its expiration, your return will equal the stated coupon rate. As bonds near their expiration, their discounts or premiums converge with par.
Hierarchy of Returns
Bond yields fall into an established hierarchy of risk and return characteristics. Generally, short-term rates are lower than long-term rates, because the probability of repayment decreases over time. However, investors seek out higher returns in the form of higher interest rates, and may invest in long-term securities. Bonds, also known as fixed income securities, are perceived as generally safe investments because of the stable interest payments they generate, and also because, in the case of a corporate bankruptcy, bondholders outrank stockholders in the preference analysis that distributes a company's liquidated assets to its investors.
U.S. government securities, such as Treasury bills, are perceived as very safe, and exhibit lower interest rates than corporate issuers. The difference in bond yields based on differences in perceived risks is known as the spread. Highly rated corporate issuers with strong balance sheets and that generate stable cash flows can borrow at lower rates than lower-rated companies, whose issuances are referred to as junk bonds. Foreign government bonds range in credit quality, with emerging market debt exhibiting higher yields.