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 If you're trying to compare a bond's yield to other investment options you've got, then you really only need four pieces of information - the bond's par value, its market price, its maturity date, and the bond's coupon rate. That's all the information you need to calculate your return from a bond. But as we'll discuss later on, really understanding bond yields is little more complex than just calculating a yield to maturity.
Bond Terminology
We've already thrown out a lot of bond terms that need a bit of explanation. If you want to understand what you're buying when you invest in a bond, then you need to understand some of the basic terms you'll be encountering.
Bond Par Value
A bond's par value is the maturity value of the bond. It is an amount that investors will receive if they hold a bond to maturity. Bond par value is also referred to as maturity value, face value, and principal amount.
Most companies issue bonds with a par value of $1,000. Government bonds, such as treasury bonds, are issue with par values in excess of $1,000, often ten times that amount or more.
Bond Market Price
The market price of a bond is the current value the market places on a particular debt issue. The market price of a bond is a function of interest rates, the issuer's financial condition, and buyers' interest.
When a bond sells for less than par value, it is said to be selling at a discount. When a bond sells for more than its par value, it is said to be selling at a premium.
Maturity Date
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 bond 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 in the future.
Bond Coupon Rates
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 bond certificate itself. Bond coupon rate is also referred to as the stated rate or the nominal rate of interest.
Bond Rate Example
The bond 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 bond with a par value of $1,000, and a coupon rate of 9.0% entitles the holder of the bond to payments of $90 per year until the maturity date.
Current Bond Yield
A bond's current yield is simply a function of the bond's current market price and the bond's coupon rate. So 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%.
Bond Yield to Maturity
A bond's yield to maturity is a way that investors can account for all of the possible returns they will get from a bond. This includes interest payments received from the bond, the possibility of reinvesting those interest payments and the difference between the price paid for a bond (or market price) and the bond's par value at maturity.
Calculating Bond Yields
Bond yields are constantly changing due to the ever changing market conditions and financial condition of the issuing company. Because of these changes, bonds rarely sell for par value. Bonds require the approval of the Securities and Exchange Commission and underwriting of the bond must also be arranged. All of this takes time and during that time market conditions and the financial condition of the company, which may affect its bond ratings, can also change.
If you understand why a bond's market value is almost never at par value, then you'll also understand 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.
This simple market fact brings us to three rules of thumb that help us to 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 happens to be selling at par value, then Coupon Rate = Current Yield = YTM.
Bond Yield Calculator
You can use our bond yield calculator to help you quickly figure out all of these different bond yields. This includes both the yield to maturity and current yield values.
All you need to run our calculator are four readily available pieces of information on the bond:
- Current Bond Price
- Par Value
- Coupon Rate, and
- Years Until Maturity
If you find a bond that you're interested in buying, you can take that bond quote and use our bond calculator to help you figure out the exact return you can expect from this investment.
Buying Bonds
Most buyers of bonds do so because they are considered relatively safe investments. Unfortunately, understanding bond yields and interpreting those values takes a bit more work then examining the percentages a calculator spits out.
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.
Bond 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 publication on Bond Ratings.
As a potential buyer of bonds, you really need to understand the risk of default, especially if you're looking a high yield bonds that would be considered "junk" bonds.
Interest Rate Risk and Bond Value
If you don't plan to hold a bond until its maturity date, then there is a second risk you need to be aware of - interest rate risk. In this example, we're going to hold everything constant (market factors, financial condition) except for interest rates.
If you buy a bond and interest rates are rising, then the market price of the bond will fall. That's because the market will demand a higher rate of interest from the bond and for that to happen, the price of the bond must fall.
Bond Value Example
For example, let's say you buy a bond with a par value of $1,000 for $900 and the coupon rate is 9.0%, your current yield is $90 / $900 or 10.0%. But if interest rates rise and the market demands 11.0% from that same bond, then price of the bond must fall to $90 / 0.11 or $818.18.
As a bondholder, you're still getting your $90 per month, but the market price of your bond just dropped $900 - $818.18 or $81.82. Conversely, if you buy a bond and interest rates decline, then the market price of the bond will rise.
Again, this drop or rise in the bond price is meaningless if you intend on holding the bond until maturity.
Buying Bonds Through a Broker
By far the most common way to buy bonds is through a broker and /or via a brokerage account. Here you've got the same choices you'd have with stocks including a full service broker or a discount (less expensive) broker. When you buy a bond you will pay a sales commission, the same way you would when you're buying a stock. So it pays to shop around and compare fees.
Bonds can be purchased via a direct offering of newly issued securities or in the secondary market. And your purchase options are pretty much unlimited when it comes to bonds. You'll find everything from the highest rated 30 Treasury bonds to junk bonds from companies about to declare bankruptcy.
But with bonds you usually get what you pay for. And just keep that in mind when you're wondering if buying a junk bond is a good idea because of the relatively high rate of interest they're paying.
About the Author - Understanding Bond Yields
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