Characteristics of a Bond
There are three important things to know about any bond before you buy it: the par value, the coupon rate, and the maturity date. Knowing these three items (and a few other odds and ends depending on what kind of bond you are buying) allows you to analyze the bond and compare it to other potential investments.
- Par value is the amount of money the investor will receive once the bond matures, meaning that the entity that sold the bond will return to the investor the original amount that it was loaned, called the principal. As mentioned earlier, par value for corporate bonds is normally $1,000, although for government bonds it can be much higher.
- The coupon rate is the amount of interest that the bondholder will receive expressed as a percentage of the par value. Thus, if a bond has a par value of $1,000 and a coupon rate of 10%, the person holding the bond will receive $100 a year. The bond will also specify when the interest is to be paid, whether monthly, quarterly, semi-annually, or annually.
- The maturity date is the date when the bond issuer has to return the principal to the lender. After the debtor pays back the principal, it is no longer obligated to make interest payments. Sometimes a company will decide to "call" its bond, meaning that it is giving the lenders their money back before the maturity date of the bond. All corporate bonds specify whether they can be called and how soon they can be called. Federal government bonds are never called, although state and local government bonds can be called.
How to calculate bond yields
The key piece of information to know about a bond in order to compare it with other potential investments is the yield. You can calculate the yield on a bond by dividing the amount of interest it will pay over the course of a year by the current price of the bond.
If a bond that cost $1,000 pays $75 a year in interest, then its current yield is $75 divided by $1,000, or 7.5%.
|Current yield =||$75|
|= 0.075 = 7.5%|
Why bond yields can differ from coupon rates
Why not just look at the coupon rate to determine the bond's yield? Bond prices fluctuate as interest rates change, so a bond can trade above or below the par value based on what interest rates are. If you hold the bond to maturity, you are guaranteed to get your principal back. However, if you sell the bond before it matures, you will have to sell it at the going rate, which may be above or below par value.
Say you bought a $1,000 bond with a coupon rate of 10% that matures in 10 years. This bond would pay you $100 per year for a decade, at which time you will get back the $1,000 in principal.
Now say you still own that bond seven years later, when long-term interest rates touch 5%. Newly issued bonds, paying that interest rate, would only pay $50 a year, not $100. As a reflection of the fact that interest rates have dropped since the coupon rate was set on the bond, you would actually be able to sell your bond for more than the $1,000 par value. This is because an investor would be willing to pay a premium rate for a bond that paid 10%.
If you hold a bond to maturity, you won't lose your principal as long as the borrower doesn't default or go belly-up. If you buy and sell bonds before they mature, you can make or lose money on the bonds themselves completely separate from the interest rates. How much more you are going to get depends on the exact maturity date of the bond, where interest rates have moved, and the transaction costs involved.
Yield to maturity
Because you can buy a bond above or below par value, bond investors often use another kind of yield called "yield to maturity." The yield to maturity includes not only the interest payments you will receive all the way to maturity, but it also assumes that you reinvest that interest payment at the same rate as the current yield on the bond and takes into account any difference between the current par value of the bond and the actual trading price of the bond at that time.
If you buy a bond at par value, then the yield to maturity will be very close to the current yield, which is exactly the same as the coupon rate. Yield to maturity is especially important when looking at zero-coupon bonds, a special type of bond that pays no interest until the maturity date, when you receive all of your principal back plus interest for the entire period the money was borrowed. Because zeros have no present yield, any yield you see associated with them is always a yield to maturity.
OK, you've decided that bonds have a place in your portfolio. How do you actually buy a bond? We discuss that very topic right... now.