Understanding Bond Yields
It's possible to compare bond yields to other investments using only four data points: par value, market price, maturity date, and the coupon rate. That's all the information needed to calculate the return from a bond. But as will be discussed later on, understanding the value derived from a bond is more complex than just calculating a yield to maturity.
Up to this point, several bond terms have been used, and they may need an explanation. It's also important to understand the security's terms and conditions, as well as features before buying a bond. This article provides this information in the sections below.
A bond's par value is the worth of the bond when it matures. It is an amount that investors will receive if they hold the bond to maturity. It's also referred to as the maturity value, face value, and principal amount.
Most companies issue bonds with a par value of $1,000. Government issues, such as Treasury bonds, often have values in excess of $1,000.
The market price of a bond is the current value the market places on a particular debt issue. The market price is a function of interest rates, the issuer's financial condition, and buyers' interest. When a bond sells for less than its par value, it is said to be selling at a discount. When it sells for more than its par value, it is said to be selling at a premium.
The maturity date of a bond is the date on which the issuing company would pay the holder of the bond its par value. Once paid, the company issuing this debt is no longer obligated to make interest payments on the security, and the debt is said to be retired.
There are certain bond features that allow the issuing company to retire a bond before its maturity date. These are called callable bonds. Maturity dates can be as long as 30 years into the future.
A bond's coupon rate is the interest rate that is written into the terms of the bond indenture, and this value often appears on the certificate itself. The coupon rate is also referred to as the stated rate or the nominal rate of interest.
The coupon rate is the interest rate the bondholder will receive, and this rate is expressed as a percentage of the bond's par value. For example, a security with a par value of $1,000, and a coupon rate of 9.0%, entitles the holder to payments of $90 per year until the maturity date.
A bond's current yield is a function of its current market price and the coupon rate. The current yield on a bond with a market price of $900, a par value of $1,000, and a coupon rate of 9.0%, would be $90 / $900 or 10.0%.
Yield to Maturity
A bond's yield to maturity is a measure that allows investors to account for all of the possible returns received from the bond. This includes interest payments and the difference between the price paid for a bond (or market price) and its par value at maturity.
The yield of a bond is constantly changing due to ever shifting market dynamics and financial condition of the issuing company. Because of these changes, bonds rarely sell for par value. Before releasing to the market, companies require the approval of the Securities and Exchange Commission and underwriting of the bond must also be arranged.
This process takes time, and during that time, the market as well as the financial condition of the company will change. This is why bond issues almost never sell at par value. It's also why the bond's coupon value is almost never the same as the current bond yield or yield to maturity. Bonds almost always sell at a premium or discount to their par value.
There are three rules of thumb to help understand the relationship between coupon rate, current yield, and yield to maturity or YTM.
- If a bond sells at a premium to par value, then: Coupon Rate > Current Yield > YTM.
- If a bond is selling at a discount to par value, then: Coupon Rate < Current Yield < YTM.
- If a bond is selling at par value, then Coupon Rate = Current Yield = YTM.
This website publishes a bond yield calculator that can determine the yield to maturity as well as current yield values. All that is required are four readily-available pieces of information: current price, par value, coupon rate, and years until maturity.
Investors buy bonds because they are considered relatively safe investments. Unfortunately, understanding bond yields and interpreting those values takes more work than simply examining the percentages a calculator provides.
All bonds carry a risk of default, or non-payment, of principal and interest. No matter how small it might be, even government issued bonds carry a risk of default. That's why investors have come to depend on bond ratings to help them understand this risk.
Credit quality ratings are issued by third parties such as Standard and Poor's, Moody's and Fitch Ratings. These rating agencies use an alphanumeric system that qualifies credit risk from investment grades through default. We've discussed this entire rating system in our article: Bond Ratings.
As a potential buyer of bonds, it's important to understand the risk of default, especially when evaluating high yield bonds that would be considered "junk" quality.
Interest Rate Risk and Bond Value
If an investor does not plan to hold a bond until its maturity date, then they encounter a second threat: interest rate risk. In this example, we're going to hold everything constant (market factors, financial condition) except for interest rates.
When interest rates are increasing, the market price of the bond will fall. That's because the market will demand a higher rate of interest from a bond, and for that to occur, the price of the security must fall. This is illustrated in the example below.
Bond Value Example
Let's say Ann buys a bond for $900 with a par value of $1,000. If the coupon rate is 9.0%, then her current yield is $90 / $900, or 10.0%. If interest rates rise, and the market demands 11.0% from that same bond, the price of the bond must fall to $90 / 0.11, or $818.18.
As a bondholder, she's still receiving $90 per month, but the market price of the bond just dropped from $900 to $818.18, or $81.82. Conversely, if she buys a bond and interest rates decline, the market price of the bond will rise.
This drop, or rise, in the bond price is meaningless if the investor intends to hold the bond until maturity.
By far the most common way to buy bonds is through a broker and /or via a brokerage account. The investor has the same choices they'd have with stocks, including a full service broker or a discount (less expensive) broker. When buying a bond, a sales commission is paid. The fee structure works the same way it would when buying a stock. It pays to shop around and compare fees.
Bonds can be purchased through a direct offering of newly issued securities or in the secondary market. An investor's purchase options are pretty much unlimited when it comes to bonds. They'll be able to find everything from the highest rated 30-year Treasury bonds to junk bonds issued by companies about to declare bankruptcy.
As is the case with all securities, the investor usually gets what they pay for. It's important to keep that fact in mind when wondering if buying a junk bond is a good value because of the relatively high rate of interest they're paying. Higher rewards often come with higher risks too.
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