Bonds: Let's Talk Yield

When it comes to investing in bonds it is easy for people to get confused when it comes to the different yields that are quoted. For example what is the difference between Yield to maturity, yield to call, current yield, coupon rate, and par value?

Let’s talk about par value. A bonds par value is the maturity value of the bond, or the amount the bond holder will receive when the bond matures. To receive this amount the bond holder holds the bond until its maturity date. Most bonds are issued with a par value of $1000. Government and municipal bonds are often issued with greater par values, sometimes as high as $10,000 or more.

Maturity Date: This is the pre determined date that the bonds will be retired and the bond holders will receive par value for the bonds, regardless what the current rate is at the time. In other words, if interest rates are higher than they were when your bond was issued, it will have lost value. However because the bonds were held to maturity, par value is paid out to bond holders. The issuer is no longer obligated to pay out interest payments.

Coupon Rate: Here is where people begin to get confused. The coupon rate determines the amount paid out to bondholders, and is split by two payments, once every six months. If you’ve got an issue that has a 6% coupon, and you purchased the bond at face value of $1000 your payment is $60, paid out in two payments of $30. The coupon rate never changes, even when the bond’s value changes due to market conditions.

Current Yield: Thecurrent yield on a bond with a market price of $900, a par value of $1000, and a coupon rate of 9% would be $90/$900 or 10%

Bond Yields: Bond yields are constantly changing with the market. One day an issue may be trading at par value, then two hours later the market changes and that same issue is selling at a discount.

Here are three rules of thumb to go by that may help clearing things up a bit.

1. If a bond sells at a premium to par value (par value is $1000) then: coupon rate >current yield > Yield to Maturity.

2. If a bond is selling at a discount to par value then: Coupon rate < Current Yield<Yield to Maturity

3. If a bond is selling at par then: Coupon Rate = Current Yield= Yield to Maturity

The longer the bond issue, the more you are exposed to risk and so are paid a premium for the trouble. If you want a shorter issue you have two options. First of all, you can purchase a new issue at the market at par value, or you can purchase your bonds in the secondary market. If for example, your son is going to need twenty thousand dollars in ten years for college. You can go to the secondary market and buy a thirty year bond that was issued twenty years ago.

The current yield you get will depend upon the bonds coupon and the price you pay for the bond. If the coupon is 10% and par value $1000 you will get $100 dollars a year from that bond. If you buy the bond for $900 dollars it is selling at a discount and your current yield is higher because the coupon never changes. If you paid a premium of $1090 then your current yield will be less than par value. Your coupon payment is still $1000 but you make less money because you had to pay that extra 90 dollars.

Remember, if you buy an issue and rates decline, you can still get back your investment when the bond matures. Market valuations have nothing to do with the coupon payment you will be receiving. You can pretty much buy any length of maturity by calling your broker and having him search inventories for a long bond that has been out on the market for some time. So if you are looking for a two year bond you do not necessarily have to buy a new issue 2yr note and sometimes you can get a better yield if you are willing to take on a little risk.

One nice thing about buying a bond that has been out for awhile is it will have likely passed the bonds call dates and you do not have to worry getting your bonds getting redeemed. Most bonds have call provisions that are usually within the first five years of the issue date. For those willing to take on the uncertainty of their bond being called there usually is a small premium.

With any investment there is some inherent risk associated with it (even with bonds), so talk to your advisor and do some research and you will have a much better chance of having a positive investing life.

Good luck and happy investing.