Bonds are IOUs that will eventually pay a certain principal amount. They also usually pay interest in the meantime. That interest is generally more than we could get on insured bank deposits, although that extra yield is not free – the FDIC does not insure bond yields so there is additional risk. For many investors though, carefully selected low-risk bonds can be a good alternative.
Understanding the investment return on bonds is straightforward but involves a little more than meets the eye. The main terms used to describe bond returns include:
- Coupon rate or nominal rate
- Current yield
- Yield to maturity
To define these we’ll need a couple other definitions first:
- Par Value (also face value or principal amount) is the amount that the bond issuer will repay.
- Maturity Date is the date on which they will pay it
How Bond Returns Work
Assume the following about a bond (this is an actual example):
~ Par Value = $1,000
~ Current Bond Price = $1009.10
~ Coupon rate = 1.7%
~ Time to Maturity: 1 year
~ The Coupon rate is 1.7%. That means that the bond will pay 1.7% X $1,000 = $17.00 annually for each bond.
The Current Yield would be 1.685%. This is calculated as follows:
~ Interest received in a year / cost of bond
~ = $17.00 / $1009.10 = 1.685%
Because the current cost of the bond, $1009.10, differs from the par value of $1,000, a 1.7% coupon does not yield 1.7%. $17 on $1,000 would be 1.7%. But $17 on $1009.10 is only 1.685%.
Current Yield vs. Coupon Rate
So Current Yield calculates the return as a percentage of the bond’s current price, not of its par value as the coupon rate does. Current yield is therefore a more accurate picture of the bond return than Coupon Rate. However, it still fails to take into account one other factor: To buy this bond today, we would have to pay $1009.10. That is a premium of $9.10 (.91 of 1%) over the $1,000 par value. We will not get that premium back. When the issuer repays the bond, they only pay the $1,000 par value. So the premium we paid reduces our return. The calculation that takes this last factor into account is called Yield to Maturity.
Yield to Maturity
In this case, the Yield to Maturity would in essence subtract the .91% premium from the 1.685% current yield: 1.685% – .91% = .784%. This is an oversimplified version of this calculation. If the bond matured more than a year into the future, the premium would be spread out over more years, so it would reduce each year’s yield by a lesser percentage, but you get the idea. The total bond return must take into account not only the amount of money to be received in interest, but also the cost of the bond.
If you do plan to hold bonds until they mature, then the most relevant calculation for you is Yield to Maturity. Fortunately, we don’t have to make any of these calculations ourselves. They are built into several bond market screening web sites, where we can also compare bonds. One of the easier-to use ones of these is from Yahoo Finance.
Bonds can be an important addition to a portfolio for those investors who seek yields that are higher than those available on bank deposits, want to shield some of their funds from the stock market, and are willing to do some homework.
Understanding the way their returns work is a first step. Bonds are one of the topics covered in our ProActive Investor Course and in the ProActive Investing XLT (Extended Learning Track). Ask your local Online Trading Academy center for details.
Source:: Understanding Bond Returns