Suppose the bond is issued at par, meaning that the offer price is 100%, and offers a coupon of 7%pa fixed. In this case an investor who bought the bond would pay 100% of the notional amount of the bond i.e. for £10,000 of bonds the price would be £10,000. In return he would receive an annual coupon of £700 as long as he held the bond and a final payment of £10,000 on maturity i.e. the final bond price would be 100%. The chart below shows the payments for this bond.
|The 7% interest payable on the bond would be set at the current level of five-year interest rates plus an additional amount to cover the risk that the particular company might default on its bond. Clearly a company with a lower credit quality would have to pay a higher rate. Typically, companies that wish to borrow via the bond market obtain a credit rating from an agency such as Moody's or Standard and Poors, which provides a way for investors to assess the relative riskiness of different bonds in the market.
Now suppose that the general level of interest rates rises. In this case the same company would be required to pay a higher rate of interest on any new bonds that it issued. However the existing bond paying 7% is still in issue and so anyone wishing to sell this bond would not expect to be able to obtain the same price, 100%, that it was issued at because of the rise in interest rates that has occurred.