In our first article in this series, we described how companies used bonds to fund their growth. We also described the four basic types of bonds issued by companies or government agencies. In this next article, we will review bond terminology, as well as the process for calculating bond yields.
Common Bond Terms
During their research, investors will encounter terms such as par value, maturity date, and coupon rate. Knowing these three variables, plus the current price of the bond, allows the investor to make fair comparisons between bond offerings of equivalent risk.
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Par value is the amount of money the investor will receive when the bond reaches its maturity date. This means the issuing entity will return to the holder the principal of the loan. The par value of most bonds issued in the United States is $1,000.
On the maturity date, the bond issuing company, or agency, will return to the bondholder the par value, or loan principal. (There are certain exceptions to this rule that are discussed later in this series, when redemption features are described.) Generally, a maturity date is categorized as short term (maturities up to one year), intermediate or mid term (maturities from 12 months to ten years), and long term (maturities over ten years).
Coupon rate is the term used to describe the interest rate a bondholder will receive, and the frequency of payment. The interest rate is expressed in terms of the bond's par value. For example, a bond with a par value of $1,000, and a coupon rate of 7.0%, means the investor can expect to be paid $1,000 x 0.07, or $70 annually.
Calculating Bond Yields
There are only two pieces of information needed to calculate bond yields: the coupon rate and the price paid for the bond. If an investor purchases a bond for $1,000 that pays $80 each year in interest, the current yield is calculated as:
Current Yield = $80 / $1,000 = 0.080 or 8.0%
Some individuals might be wondering why it's not possible to look at the coupon rate to determine the bond yield. Unfortunately, the solution is not that simple.
Bond Yields and Coupon Rates
When bonds are sold, the issuer normally attempts to structure the offering such that a bond sells on the market at a price close to its par value. A company takes into consideration several factors when establishing the coupon rate of a bond:
The interest rate curve, which is the direction interest rates are thought to be going (long and short term rates) between the issuing date and maturity date.
The risk associated with the issuing entity, which is the probability of default or non-payment of interest on the bond, or the non-payment / return of the principal.
The bond's redemption features, which can be used to mitigate risk to either the investor or the issuing entity.
As time marches forward, these three variables will change, which means the current price of a bond might be lower, or higher, than the bond's par value. The following example demonstrates how this can happen.
Bond Pricing Example
Company Z issued a $1,000 bond in 1987 (when long-term interest rates were high) at a coupon rate of 12% and a maturity date of 2017. Company Z also issued $1,000 bonds with identical features in 2010, with a coupon rate of 6%.
The individuals purchasing bonds issued in 1987 receive $120 per year in interest payments, while those that purchased bonds issued in 2010 only get $60 each year. Everything else being equal, the 1987 bond's current price would be higher (more on this later) than the current price of the 2010 bond. In other words, investors are willing to pay more than the par value for the 1987 bond because the coupon rate is twice as high as the 2010 issue.
Bond Yield to Maturity
A second calculation allows investors to make more accurate "apples-to-apples" comparisons between bonds. Using the current selling price of the bond, its coupon rate, and maturity date, it's possible to calculate the bond's yield to maturity.
Bond Yield to Maturity Example
To see how this calculation works, we will continue with the example described earlier. Let's further assume the bond issued in 1987 is currently selling at $1,200. This would mean the bond yield is $120 divided by $1,200, or 10%.
Why wouldn't the bond be selling at $2,000 to yield 6%, just like the 2010 bond?
The 1987 bond is maturing in 2017, and the holders of this security are only going to receive its par value of $1,000. They paid more than the par value ($1,200) to get the higher bond yield, but the yield to maturity takes into account the holder will "lose" $200 (the selling price of $1,200 minus the par value of $1,000) when the bond matures in 2017.
The concept of yield to maturity really comes into play when valuing zero coupon bonds. These securities do not provide the investor with interest payments, rather the bond's value climbs over time as the maturity date nears, and the holder is entitled to collect the par value ($1,000). That means zero coupon bonds are issued at a price that is well below their value at maturity.
Anyone that would like to run through some additional examples that involve yield to maturity can use our online bond yield calculator.
In the next article in this series, we will describe bond redemption features and credit quality.
About the Author - Investing in Bonds Part II
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