Unchanged

• The terms of the bond reflect the prevailing interest rate in the economy when a bond is issued to investors for the first time. When a bond is first purchased the prevailing interest rate is commonly equal to the coupon rate. The coupon rate is the annual interest payment the bond will pay its holder. The coupon rate is commonly a percentage of the face value of the bond. At this point, bonds may sell quickly.
  
  

Increase

• However, once the bond is traded in the bond market, it is exposed to the effects of increasing interest rates. If the interest rate increases beyond the coupon rate the bond is originally paying, the bond will likely be sold at a price lower than the face value of the bond to entice buyers. When this happens, a bond is said to be a discount bond. The purpose of selling a bond at a discount is because the new buyer expects to receive the new, higher interest rate.
  
  

Decrease

• However, if interest rates decrease below the bond's original interest rate the price of the bond will increase. In this case, the bond is called a premium bond. Selling a bond under these conditions is likely to command a price above the face value which favors the seller of the bond. In return, the buyer may profit from the higher interest rate payments of the bond as long as interest rate levels remain below the bond's interest rate payments.
  
  

Inverse Relationship

• A basic rule to remember about interest rates and the bond market is that whenever interest rates increase above a bond's particular interest rate, the value of the bond will decrease. In contrast, if interest rates fall below a bond's interest rate, the price of the bond will increase.
  
  

Considerations

• Although the bond market is very sensitive to changes in interest rates, buying and selling bonds is also subject to additional considerations that may affect the overall return from investing in bonds. For example, taxes may increase the costs of investing in a particular bond and reduce the gains for the owners. Taxes in this case may be paid in the form of income or as capital gains tax.