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 In our first article in this series on investing in bonds, we described how companies used bonds to fund their growth. We also described the four basic types of bonds that are issued by companies or government agencies to the public. In this part of the series we will describe some bond terminology, and the process for calculating bond yields.
Common Bond Terms
When you are looking to buy a bond, the most common terms you will encounter is the par value, maturity date and the coupon rate. If you know these three things plus the current price of the bond, then you have enough information to make comparisons between bond offerings or other investment options.
Par Value
Par value is simply the amount of money that the investor will receive when the bond reaches it maturity date. This means that the issuing entity will return to the bond holder the par value or principal of the loan. On the vast majority of bonds issued in the United States, the par value or loan principal is $1,000.
Maturity Date
Maturity date is a future date in time at which the bond issuing company or agency has agreed to return to the bond holder the par value or loan principal. There are certain exceptions to this rule that we will discuss later when describing redemption features. Generally, maturity date is categorized as short term (maturities up to one year), intermediate or mid term (maturities from twelve months to ten years) and long term (maturities over ten years).
Coupon Rate
Coupon rate is a term used to describe the interest rate that the bond holder will receive and the frequency of payment. The interest rate is expressed in terms of the par value of the bond. For example, a bond with a par value of $1,000 and a coupon rate of 7.0% means that the bond holder can expect to be paid $1,000 x 0.07 or $70 annually.
Calculating Bond Yields
Now that we understand the fundamental terminology used to describe bonds, we are ready to talk about calculating bond yields. But we want make it clear up front that there are several more variables that we will discuss later that are important considerations before investing in bonds - such as redemption features and yield to maturity. Warnings aside, here is the process you can use for calculating bond yields.
There are really only two pieces of information you need to calculate bond yields - the coupon rate and the price paid for the bond. So if you were to purchase a bond for $1,000 that paid $80 a year in interest then the current yield is calculated as follows:
Current Yield = $80 divided by $1,000 = 0.08 or 8%
Some of you might be wondering why we didn't just tell you to look at the coupon rate to figure out the bond yield. Unfortunately, the solution is not that simple.
Bond Yields and Coupon Rates
When bonds are issued the issuer normally attempts to structure the bond offering such that the bond sells on the market at a price that is pretty close to its par value. So a company issuing a bond takes into consideration several items when issuing a bond and establishing its coupon rate:
- The interest rate curve - which is simply the direction interest rates are thought to be going (long and short term interest rates) between the issuing date and maturity date.
- The risk associated with the issuing entity or the probability of default or non-payment of interest on the bond or return of the principal.
- The bond's redemption features - which can be used to mitigate risk to either the investor or the issuing company.
But as time marches forward, these three variables change over that time. This means that the current price of a bond might be lower or higher than the par value. Let's look at a quick example of how that can happen.
Bond Pricing Example
Let's say that Company Z issued a $1,000 bond in 1982 (when long term interest rates were high) at a coupon rate of 12% and a maturity date of 2009. Let's also assume that Company Z issued $1,000 bonds with identical features in 2005 at a coupon rate of 6%.
Those individuals investing in bonds issued in 1982 receive $120 per year in interest payments, while those investing in bonds issued in 2005 only get $60. Everything else being equal, the 1982 bond's current price would be nearly double (there is more to this story) the current prices of the 2005 bond. In other words, investors would be willing to pay more than par value for the 1982 bond because the coupon rate is relatively high.
Bond Yield to Maturity
To allow investors to make "apples-to-apples" comparisons between bonds, they use a second calculation that takes into account the current selling price of the bond, its coupon rate and maturity date. All this information together can be used to calculate the bond yield to maturity. This calculation makes investing in bonds a little easier.
Bond Yield to Maturity Example
To see how this calculation works, we will continue with the example described above. Let's further assume that the bond issued in 1982 is currently selling at $1,200. This would mean the bond yield is $120 divided by $1,200 or a 10% yield.
Why wouldn't the bond be selling at $2,000 to yield 6%, just like the 2005 bond? That's because we need to be aware of the bond's par value. The 1982 bond is maturing in 2009 and those investing in these bonds are only going to receive its par value of $1,000. So they paid more than par value ($1,200) to get the higher bond yield, but the yield to maturity takes into account that the holder will "lose" $200 (price of $1,200 minus par value of $1,000) over the course of the next two years when the bond matures in 2009.
Where this concept of yield to maturity really comes into play is when valuing a special kind of bond termed a Zero Coupon Bond. These bonds do not provide the investor with interest payments, rather the bond price 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 well below their value at maturity.
If you'd like to run through some additional examples of how to calculate bond yields and yields to maturity, you can use our online bond yield calculator.
This is a good place to stop this lesson. In our next article in our series on investing in bonds, we will describe bond redemption features and credit quality.
About the Author - Investing in Bonds Part II
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