Investing in Bonds Part II

In our first article in this investing in bonds series, 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 next installment, we will review some bond terminology, as well as the process for calculating bond yields.

Common Bond Terms

When you are looking to buy a bond, the most common terms you'll encounter include par value, maturity date, and coupon rate.  If you know these three variables, plus the current price of the bond, then you have enough information to compare the bonds being offered and other investment options.

• Par value is the amount of money that the investor will receive when the bond reaches its 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 is a future date in time at which the bond issuing company, or agency, has agreed to return to the bondholder the par value or loan principal.  There are certain exceptions to this rule that we will discuss later in this series when describing redemption features.  Generally, 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 a term used to describe the interest rate that the bondholder 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 bondholder 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.  We want to make it clear up front that there are several more variables that will be discussed later.  These are important items to consider before investing in bonds, such as redemption features and yield to maturity.  Those warnings aside, here is a process that can be used to calculate 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 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 = 0.080 or 8.0%

Some individuals 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 close to its par value.  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 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, 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 company.

As time marches forward, these three variables will change.  That means the current price of a bond might be lower, or higher, than the bond's par value.  Let's look at a quick example of how this can happen.

Bond Pricing Example

Let's say that 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 2014.  Let's also assume that Company Z issued $1,000 bonds with identical features in 2010, with a coupon rate of 6%.

Those individuals investing in bonds issued in 1987 receive $120 per year in interest payments, while those investing in bonds issued in 2010 only get $60.  Everything else being equal, the 1987 bond's current price would be nearly double (more on this later) the current price of the 2010 bond.  In other words, investors would be willing to pay more than par value for the 1987 bond because the coupon rate is relatively high.

Bond Yield to Maturity

To allow investors to make "apples-to-apples" comparisons between bonds, a second calculation takes into account the current selling price of the bond, its coupon rate, and maturity date.  This information can be used to calculate the bond yield to maturity.  This calculation also 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 1987 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 2010 bond?  We need to be aware of the bond's par value.  The 1987 bond is maturing in 2014, and those investing in these bonds are only going to receive its par value of $1,000.  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 (selling price of $1,200, minus the par value of $1,000) over the course of the next five years when the bond matures in 2014.

The concept of yield to maturity really comes into play 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 that is well below their value at maturity.

If you'd like to run through some additional examples involving the calculation of 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.

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