Investment Bonds Primer

Investment Bonds Primer Erik J Abel [email protected]

Who Issues Bonds and Why? ..............................................................................................4 Bond Structure .....................................................................................................................5 Payment Structure................................................................................................................6 Risk ......................................................................................................................................7 Credit Risk ...........................................................................................................................8 Issuer Type.....................................................................................................................8 Length to Maturity .......................................................................................................10 Credit Rating (Risk Premium) .....................................................................................11 Call Provision Risk ......................................................................................................11 Interest Rate Risk...............................................................................................................12 Issuing Bonds: The Primary Market ..................................................................................13 Coupon Rate.................................................................................................................13 Credit Enhancements ...................................................................................................13 Negotiated or Competitive Offering ............................................................................14 Pricing Bonds: The Secondary Market ..............................................................................14 Bond Yields .......................................................................................................................16 Nominal/Current Yield ................................................................................................16 Yield to Maturity..........................................................................................................17 True Yield ....................................................................................................................18

© 2009 Erik J Abel [[email protected]]

Investment Bonds Primer Purpose This tutorial provides a comprehensive overview of the purpose of investment bonds. It describes where they come from, and how they function as financial instruments, and in the bond market. The process of structuring bond issues over the years has developed many conventions and features. There are also many less-common, creative and novel structures and features. This tutorial does not address every possible bond construct. It describes many of the fundamental and most common structures and features to get you started in understanding investment bonds. This tutorial does not: • Provide investment advice • Guide you in developing a strategy for how to invest in bonds • Guide you in choosing in which type of bonds to invest

Acknowledgements I wish to express my deep felt appreciation to the people (O.G. and J. P.) who shared their knowledge and time in reviewing this document and providing thoughtful comments and corrections. I’m grateful for the improvements that their help initiated. I also wish to thank D.S. for her loving encouragement and support and for motivating me to edit.

© 2009 Erik J Abel [[email protected]]

Investment Bonds Primer Erik J Abel To function in an economy - to run a government, to manage a business, to conduct our lives – on occasion, we need to borrow money. As individuals, we can borrow money – get a loan – from financial institutions, friends or family. Governments and businesses have the credit-worthiness to borrow money from the financial markets. Issuing bonds is the method by which governments and businesses borrow money from the financial markets. A bond is similar to a personal loan. Think about what you would want to know if you were asked to make someone a loan and you will understand the basic terms of a bond: • • • •

How much do they want to borrow? For how long is the money needed and when will you be paid back in full? What are you going to get in return for lending the money? When are they going to give this to you? At regular intervals throughout the term of the loan? At the end of the loan period, when they pay back your money in full? How much do you trust that you will get paid back?

However, a major difference between your buying a bond and making a personal loan is that you may seek to purchase a bond because of its value to you as an investment. As such, you will shop for a bond that meets your financial objectives in terms of how much you expect to earn from it. How much you can expect to earn on a bond is determined by many factors. Some of these factors include the length to maturity of the bond and the credit rating of the bond and the bond issuer. But bonds are not only loans. Because a bond holder may want to be paid back in full before the bond matures (before the issuer is obligated to do so), bond holders can and do sell their bonds to others. Thus bonds are also financial instruments that can be traded in the financial markets, known in the industry as the secondary market. The value of a bond to an investor is as a fixed income investment – an investment that pays the investor regularly scheduled amounts over time for the use of their money. This concept of a fixed-income, a future cash-flow, informs how bonds are priced in the financial markets. In the financial markets the finance theory concept of a discounted cash-flow is used to establish current prices for bonds. Now, we conclude our introduction to bonds with a more formal description of what a bond is:

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A bond is a negotiable financial instrument known as a debt security. A bond issuer asks a bond holder to give them an amount of money for a period of time. In exchange, the issuer promises: • To pay the full amount of the loan back to the holder at a predetermined time in the future • To reward the holder by paying a percentage of interest on the amount invested • To pay this at regular intervals throughout the life of the bond, or at maturity in a lump sum larger than the amount the bond holder invested. It is a formal contract to repay borrowed money with interest at fixed intervals.

Who Issues Bonds and Why? The sale of bonds in the financial markets is regulated. For a bond to be bought and sold on the financial markets - to be a marketable financial instrument - it must be registered with and follow the rules of securities regulators. Regulators limit the ability to issue bonds as marketable debt securities to those parties who can demonstrate the ability to repay the debt based on current earnings. Few institutions have the cash-flow or personnel resources to demonstrate this. Therefore, issuing bonds as a registered offering on the financial markets is limited in the United States to primarily three types of parties: • • •

The Federal government and Federal agencies State and municipal governments Corporations including: o Public utilities o Transportation companies o Industrial corporations o Financial services companies o Conglomerates

The U.S. federal government issues bonds to cover some portion of its regular expenditures. It meets regulators criteria of demonstrating the ability to repay debt, because the federal government always has the option of raising taxes to redeem the bond at maturity. State governments obtain their source of security for debt typically from income or sales taxes; Municipal governments usually from property taxes; agencies - such as water or turnpike authorities - through fees; and local governments from property taxes. Corporations issue bonds to fund operations or growth. The types of corporations that can issue bonds are generally businesses with a good cash flow such as utilities with an exclusive contract to provide a service. Corporations can raise capital through stock offerings and bank loans. However, they may choose to raise it through bond offerings because: • Companies view borrowing from a bank as more expensive than issuing bonds

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•

Cost of equity is consider more expensive than cost of debt as: - Stock dividends are taxed as income - Interest on debt is tax-deductible as an expense, and so reduces a corporation’s income tax burden We’ll get into the process by which institutions issue bonds in a later section. First, let’s get familiar with the structure of a bond.

Bond Structure As an investment, bonds provide you with a cash-flow over a set period of time including the return to you of the face value of the bond. Bond issuers provide you with this cashflow in exchange for their use of your money now. Bonds - like loans - are subject to credit risk, that is, the risk that the issuer will default or stop paying you what the terms of the bond promised. The structure of a bond includes the following components: Bonds are commonly issued in $1000 (to $5000) increments. This is the principal amount that the issuer repays when bond reaches maturity; the par or face value of the bond. Amount that a bond buyer pays for a bond which may be Price above or below face value. Above par = premium Below par = discount Time in the future when issuer repays principal value of bond Maturity to bond holder. Interval ranges from 1 month to 40 years. Interest/Coupon/Yield Interest Interest rate fixed at time of bond issuance. A percentage of the bond amount paid to bond holder at regularly scheduled intervals over the life of the bond. Called nominal interest. Various factors go into determining the interest paid on the bond including: market interest rates and the credit risk-level of the bond and issuer. Face/Par Value

Coupon The interest paid on a bond is also called the coupon. This term comes from the no longer used practice of issuing physical paper certificates with coupons attached representing each interest payment. The bond holders would detach and redeem the coupons to receive each interest payment. Yield. Interest is often referred to as yield; however yield has a number of meanings in relation to bonds in addition to nominal interest rate. In evaluating bonds, yield tells you the annual rate of return.

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Bonds are categorized into types in part based on the following components: Payment structure

Issuer Type Level of risk

Interest rate

Call provisions

The type of payment structure the bond offers. The payment structure specifies where your cash-flow comes from: coupon or zero-coupon. Bonds are organized and tracked by type of issuer: treasuries, municipal, corporate. Factors associated with risk to the bond holder include: • Issuer type • Length to maturity • Risk-level rating by a third party agency (ranges from investment grade (safest) to junk (riskiest)). • Interest rate: o Safer bonds pay lower rates o Riskier bonds pay higher rates. Lower interest rate bearing bonds are considered safer than higher interest rate bonds. Bonds pay a higher interest rate as a premium for greater risk due to greater length to maturity or poorer creditworthiness of issuer. Some bonds come with the rights of issuers to call the bonds before maturity.

The following sections go into these bond components in more detail.

Payment Structure Bonds are categorized by the two primary payment structures: Bonds that pay interest at fixed intervals and return the face value of the bond at maturity. Zero-Coupon Bonds sold for below face value and that return the face value of the bond at maturity. These bonds do not pay a coupon, thus the name zero-coupon. U.S. savings bonds, where you pay $25 and receive $50 at time of maturity, are an example of zero-coupon bonds. Coupon

Coupon Bond Example You buy a corporate bond with the following characteristics: Face value Price Maturity Interest/Yield What you receive through bond maturity

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$1000 $1000 5 years 5 %, paid annually $1250 • $1000 principal • 5% interest per year = $50 by 5 years (5 x 50) = $250

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The coupon bond pays annual interest each year to maturity, plus returns the face value of the bond to you at maturity. Zero Coupon Bond Example You buy a U.S. Treasury Bill with the following characteristics: Face value Price Maturity Interest/Yield What you receive through bond maturity

$1000 $ 980.79 52 weeks None $1000

You purchase a zero-coupon bond at a discount from face value and are returned the face value of the bond at maturity. Although a zero-coupon bond does not pay interest while the bond is outstanding, the discount from face value is an implied interest rate (discount rate) - the rate by which the bond was discounted. You earn on your investment in a zerocoupon bond the difference between what you pay for the bond and the face value of the bond. Various types of bonds offer various tax advantages or disadvantages. You want to consider the tax treatment of various bond types before choosing in which type to invest. For example, some bonds are taxable at the federal level but not at the state or local levels, or vice versa. You must pay taxes on the interest you earn on a taxable bond at the time that you receive the interest. Although zero-coupon bonds do not pay interest, if a zero-coupon bond is taxable, it is taxed during the life of the bond as though you were receiving a percentage of your earnings as interest through out the life of the bond. So with zero-coupon bonds, you must pay taxes on money you do not yet have in your possession. On the other hand, once you do receive your earnings, you have paid off the taxes.

Risk As loans and marketable financial instruments, bonds are subject to the following types of risk: • •

Credit risk (risk of default) Interest rate risk

In addition, some bonds are also subject to issuer-rights risk in the form of call provisions.

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Credit Risk As we stated earlier, regulators limit the ability to issue bonds as marketable debt securities to those parties who can demonstrate the ability to repay the debt based on current earnings. Although an issuer might have good enough credit to qualify to issue bonds, the range of the creditworthiness of these institutions varies from being very safe from default to being more at-risk of default. In addition, an institution’s financial situation can change; an institution that was financially healthy when a bond was issued may not be so by the time a bond matures. The risk that an issuer may be unable to continue paying interest on a bond, or to buy back a bond at maturity (to pay back the loan), that it will default in some way is called credit risk and is always present to varying degrees. A bond’s credit risk is categorized by: • Issuer type • Length to maturity • Issuer’s/bond’s credit rating The market charges for bearing credit-risk. Therefore, in general, the greater the creditrisk of a bond, the higher the rate of interest that the bond pays. The following sections explain the issues that go into factoring a bond’s credit risk. Issuer Type As the various types of issuers have different methods and sources of securing the debt that they issue, they pose varying levels of credit risk. The rank of credit-risk by issuer type is as follows, from least to most risk: Less Risk •

Federal government bonds

•

Municipal/Corporate bonds

More Risk U.S. Federal Government Bonds issued by the U.S. Federal government are considered to offer the least credit risk of any bonds in the market because: • The Federal government always has the option of raising taxes to redeem a bond at maturity • The Federal government and agencies have never defaulted on a bond

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Because of the perception of their safety, federal bonds are central to the financial markets as benchmarks for valuing other debt securities. The ability to raise taxes to redeem a bond at maturity alone is not sufficient to prevent a government from defaulting on bonds; other country’s national governments have defaulted on bond issuances. One factor in some foreign government’s bond defaults is an exchange rate risk when they issue bonds in foreign denominations. For example, Argentina had issued external debt denominated in U.S. dollars rather than Argentine pesos and eventually defaulted on these bonds in 2002 due to exchange rate issues. Municipal Bonds issued by state and local governments and agencies do occasionally default. Economic or political problems can cause a government entity’s credit rating to degrade. Municipal bonds are categorized by type according to the repayment source, which offer various levels of default risk. Municipal bonds are generally of three types: Municipal Bond Type General obligation

Revenue

Assessment

Risk These bonds offer the greatest level of security because the issuer promises to repay based on the full faith, credit and taxing powers of the government that issued the bonds. These bonds must be repaid from a specific stream of income (such as utility fees). If money is not available from that income stream, bonds may not be repaid. These bonds are repaid based on property tax assessments. Because tax assessments can vary, repayment is less secure.

Corporate As a security, the ownership of a corporate bond differs from ownership in a stock in that: • Bond holders are lenders to the corporation who issued the bond. As lenders they are due to be paid back even if the company issuing the bond goes bankrupt. • Stock holders are owners of the corporation whose stock they bought, and lose their investment if the company goes bankrupt A bond-holder’s risk is in the overall financial stability of the issuer only, while a stock holder’s risk lies in the profitability and solvency of the issuer. However, not all bond holders have an equal stake on the company. Debt is categorized as follows: Backed by collateral of some kind of asset that can be seized to satisfy the debt. Unsecured Not backed by collateral. Secured

In the event of the issuers’ bankruptcy, holders of secured debt are paid first. Bonds issued as secured debt are less risky than bonds issued as unsecured debt. © 2009 Erik J Abel [[email protected]]

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Length to Maturity The longer a bond remains outstanding the greater the chance that the issuer’s financial condition can change for the worse, and that the issuer can default on the bond. The rank of credit-risk by maturity is as follows, from least to greatest risk: Less Risk

Classification

Maturity

Short-term

< 2 yrs.

Intermediate-term (Intmd)

2 to 12 yrs.

Long-term

>12 yrs.

More Risk The following diagram shows how bonds are rated for risk on a continuum by: • Issuer type - Federal securities (Fed/secs) - Municipalities (munis) - Corporations (corps) • Maturity lengths - Short-term - Intermediate-term (Intmd) - Long-term

Risk level

Maturities by issuer type

Interest rates

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Least

- Short- Fed/Secs

Lower

Some

- Short-munis - Short-corps - Intmd-Fed/Secs - Secured corps

More

- Intmd-corps - Intmd-munis - Long-Fed/Secs

Most

- Long-munis - Long-corps - Un-secured corps

Higher

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Credit Rating (Risk Premium) Credit rating agencies such as Moody's, Standard and Poor's and Fitch Ratings analyze bond issues to determine the level of risk that the bond could default. They then assign a rating to the bond that can range from various levels of investment grade to various levels of being speculative. In addition to being a gauge by which investors can determine the relative safety or risk of a bond, the credit rating also factors in to determining any additional amount of interest a bond must pay. This additional amount of interest is a premium for an investor’s willingness to take on additional risk. As shown in the following diagram: •

Higher grade bonds offer: - Lower credit risk (risk of default) - Lower interest rate risk premiums

•

Lower grade bonds offer: - Greater credit risk - Higher interest rate premiums

Credit Rating Categories

Ba1-Ba3 A1-A3

Aaa

(Upper Medium)

(Prime)

Investment Grade

(High)

Aa1-Aa3

Caa3-Ca

(Non Investment Grade)

Caa1

(Little Prospect for Recovery)

(Substantial Risk)

(Lower Medium)

(Highly Speculative)

(Extremely Speculative)

Baa1-Baa3

B1-B3

Caa2

In Default

Credit Risk

Lower

Higher

Interest Rate (Risk Premium)

Lower

Higher

A bond’s credit rating can change over time as the financial condition of the issuer changes. Bonds with lower credit ratings are more sensitive to new information about the issuer than are those with higher ratings. Call Provision Risk This is the risk that the issuer can choose to payback your bond before its maturity. A called bond thus deprives you of anticipated income through the years until the defined maturity date. A call provision is established for a bond at the time of its issuance, so you can know before you purchase a bond whether it is callable. Because of the risk of losing anticipated future income, callable bonds offer a higher coupon/interest rate than noncallable bonds.

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An issuer typically exercises the option to call a bond when interest rates go down. This way, the issuer can save money on servicing debt by retiring bonds issued at a higher interest rate and issuing new ones at a lower rate. Thus, if you want to replace a bond that was called, you will likely get a new bond with a lower coupon rate as coupon rates in the bond market at that time are lower.

Interest Rate Risk The prices of bonds fluctuate with changes in the interest rates charged for borrowing. This is known as interest rate risk. There is an inverse relationship between bond prices and interest rates. As interest rates change, the prices of bonds change in the opposite direction as follows:

Rising interest rates

Bond Prices

Rising bond prices

Interest Rates

Interest Rates

Bond Prices

Declining bond prices

Declining interest rates

We’ll get into a description of how and why this happens in the section on pricing bonds. As interest rates change the price of a bond may be at a:

Discount

Description Price is below face value of the bond.

Premium

Note: Zero-coupon bonds are sold at a discount regardless of interest rate changes. Price is above face value of the bond.

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Example Face value: $1000 Price: $ 900

Face value: $1000 Price: $1100

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Issuing Bonds: The Primary Market When an institution seeks to borrow money by issuing bonds, it must first structure the bond offering. Structuring a bond offering includes planning how much debt to take on, how to finance that debt, and preparing legal documentation. A bond issuer uses an underwriter – a registered securities dealer or investment bank – to aid in structuring the issue. The underwriter helps the issuer establish the financing terms - particularly what interest rate to pay as a coupon on the bonds; to get a rating for the bonds from a credit rating agency; and can be the primary purchaser of the bonds. Coupon Rate The underwriter sets the interest rate that the bonds pays to investors based on a combination of the following at the time the bond is issued: Factor Federal funds rate

Federal Treasury securities

Description The prevailing interest rate that banks with excess reserves at a Federal Reserve district bank charge other banks that need overnight loans. Bond issuers use the interest rates of federal securities of a similar maturity to their bond issue as a benchmark for setting the interest rate on their bonds.

And a risk premium rate based on a credit rating of the institution issuing the bonds. The credit rating is assigned by a credit rating agency such as Moody’s, Standard & Poor’s, or Fitch Ratings. Credit Enhancements An issuer can lower the risk premium set on a bond issuance through a credit enhancement. Credit enhancements include obtaining a letter of credit from a commercial bank or purchasing bond insurance. A credit enhancement allows the issuer to borrow the credit rating of the letter-of-credit or insurance provider and thus for the bonds to be rated based on the provider’s credit-rating rather than the issuing institution’s. Although obtaining a credit enhancement increases the cost of issuing bonds, it often saves the issuer money. This is so, because the credit enhancement reduces the credit risk of the bonds and thus the amount of interest the issuer has to pay on the debt. The reduced interest rate makes up for the cost of the credit enhancement. Issuers find it easier and less expensive to obtain bond insurance than letters of credit. In addition to lowering their risk premium through credit enhancements, bond issuers have many ways of strategically structuring bond issuances to minimize the overall cost of issuing debt. For example, they can reduce the cost of a debt issuance by issuing a type of bond known as a convertible bond. Because a convertible bond is viewed as offering greater safety than other types of bonds, use of these reduces the amount of interest the issuer is required to pay on the debt.

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Negotiated or Competitive Offering When the issuer chooses a firm to structure the bond issuance, it can select a firm to both structure the bond issuance and to be the underwriter (primary buyer of the bonds), or it can use different firms for each. In fact, for many sizable issues, the investment bank is actually a syndicate of a number of firms acting as one, with one firm leading. This is true particularly for the underwriting, as any single investment bank may not have the capital or desire to take the risk of funding an entire bond issuance. If an issuer selects an investment bank or syndicate to both structure and underwrite a bond issuance it is called a negotiated sale, as the issuer and underwriter negotiate the terms of the bond financing together. Since the underwriter in a negotiated offering is assured the right and obligation to purchase the bonds, the underwriter may aid the issuer in determining a market for the bonds by testing the market through its own sales channels. In a negotiated sale, the underwriter may also begin marketing the bonds before they are formally issued. If the issuer seeks a different investment bank or syndicates from the one that structured the bond issuance to underwrite it, it is called a competitive or bid offering. In this type of offering, the issuer seeks bids on the financing of the bonds from multiple underwriters. The underwriter who offers the lowest interest rate to finance the bonds wins the bid and the right/obligation to purchase and re-sell the bonds through its sales channel. The Federal Treasury securities auctions are an example of a competitive bid offering. The bond financing also includes profit for the underwriter. The underwriter typically buys the bonds for less (up to two percent less) than the price at which they sell them.

Pricing Bonds: The Secondary Market Once a bond underwriter begins to sell bonds through its sales channels to its customers, the bonds are selling on the secondary market. Both newly issued bonds and previously issued bonds that have gone unsold or that are being re-sold are for sale on the secondary market. Most bonds are sold on the secondary market in over-the-counter trading between broker-dealers rather than on an exchange such as the stock market exchanges. The sale of bonds on the secondary bond market is predicated on the idea that investors want to own the bonds with the best yields within their risk level classification. So that all bonds on the market can potentially be sold, the market prices bonds so that the yields on bonds with varying coupon rates are somewhat equivalent. To understand how bonds are priced, you must understand the idea that when you buy a bond, you are purchasing a future cash flow (your fixed income). For example, if you buy a bond with the following characteristics and hold it until maturity:

Par Value Coupon Rate $1000 5%

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Annual Coupon Payment $50

Maturity 5 years

Cash Flow $50 x 5 years

Yield $250

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Your cash flow from this bond is $50 a year for five years and you yield $250 in total by maturity. But it is a future cash flow; you do not have possession of all the $250 at present. Bonds on the secondary market are priced using a discounted cash flow model. This model is based on the finance theory concept of the time value of money. According to the time value of money concept, money you have in your possession now (present) is worth more than money you will have in the future. This is so because you can increase the value of money you have now by obtaining interest on it. Thus, the market prices bonds so that bond prices reflect the present value of their future cash flow. In so doing, the market prices bonds so that the yields of various bond issues are not widely skewed from other issues. To calculate the present value of future money, you discount its value. Some percentage is used to discount future values. In this case, an interest rate and the interest rate used to make this calculation is called the discount rate. The discount rate used for pricing bonds comes from a composite of the risk-free interest rate and benchmarks of bonds of similar structure (like treasuries). Thus, in pricing the future cash flows of bonds to their present values: Interest Rate Movement Up

Bond Price Movement Down

Down

Up

Explanation The present value of each future cash flow is worth less, since a bond offered today would have a higher cash flow/coupon rate. The present value of each cash flow is worth more, since a bond offered today would have a lower cash flow/coupon rate.

In addition, the length to maturity of a bond is a factor in a bond’s price sensitivity to interest rate changes. The longer period to maturity of a bond the greater the price sensitivity to changes in interest rates than that of bonds of shorter maturities. If you purchase a bond when it is first issued and hold it until maturity, the price volatility of bonds does not really affect you. What affects you is the rate of return on your bond compared with the rate of return on newly issued bonds. As new bond issues may have a lower or higher coupon rate than a bond that you hold, by holding your bond to maturity your rate of return may be lower or higher than the coupon rates of newly issued bonds. The price volatility of bonds affects you when you buy bonds after they are issued, or sell them before they mature. Calculating your yield on a bond that you purchase after issuance or sell before maturity is more complex.

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Bond Yields A bond’s yield tells you how much money you will make from investing in the bond. If you buy a bond at initial offering and keep it until maturity, determining the yield is relatively straight-forward; its yield is the coupon rate or the sum of all of the coupon payments. If you buy a bond on the secondary market, when the price of the bond is above or below par, calculating its yield is more complex. In this scenario, you can calculate the yield as: Current yield

Provides a comparison of the coupon rate to the current market price. That is, what percentage the coupon payment is of the price of the bond. This calculation shows what the market is willing to accept as an effective interest rate on a bond.

Yield-to-maturity (YTM)

An estimated cumulative return on a bond including: • All coupon payments • Return of face value of bond. • Compound interest on all coupon payments to bond’s maturity.

Of these two methods of calculating yield, yield to maturity is the more accurate calculation of what you will make on an investment in a bond. Nominal/Current Yield The following table describes nominal and current yield and how you can calculate each for a bond with the following characteristics: Par Value Coupon Rate $1000 5%

Annual Coupon Payment $50

Calculated For A bond priced at par. Yield (Nominal) Yield is equal to coupon rate, coupon payment amount, or sum of coupon payments. Current Yield

A bond priced below or above par.

Maturity 5 years

Calculation Coupon amount face value x coupon rate Coupon rate coupon amount / face value

Example $1000 x 5% = $50

$50 / $1000 = 5%

5% (.05) / $900 = 5.5% 5% (.05) / $1100 = 4.5%

coupon rate / price or

The effective percentage rate of return of the coupon payments given a bond priced above or below par.

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coupon amount* / price

$50 / $900 = 5.5% $50 / $1100 = 4.5%

(*calculated from face value x coupon rate)

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Another way of looking at the effects of changing bond prices: At par (face value)

Current yield is equal to coupon rate.

5%

Below par (discount)

Current yield is higher than coupon rate. 5.5% [5% / $900]

Above par (premium)

Current yield is lower than coupon rate.

4.5% [5% / $1100]

Thus, we can see that as bond prices respond to interest rates, naturally, so too do the current yields on existing bonds (and the nominal yields/coupon rates of new bond issues). Bond current yields respond with interest rates. Rising interest rates

Rising current yields

Bond Prices Interest Rates

Bond Current Yields

Declining bond prices

Rising bond prices

Bond Current Yields

Interest Rates

Bond Prices

Declining interest rates

Declining current yields

Yield-to-Maturity Again, of the methods of calculating yield for changing bond prices – current yield and yield to maturity - yield to maturity is the more accurate calculation of what you will make on an investment in a bond. This is the recommended yield to calculate when comparing different bonds that you are considering purchasing. Yield to maturity calculates an estimate of the cumulative return on a bond including: • The sum of the coupon payments • Difference you receive in return of face value of the bond, if you purchased it below or above par • Compound interest (at same interest rate as coupon rate) on coupon payments A YTM calculation is fairly complicated but basically calculates the present values of all payouts so that when you add up these present values, the sum will equal the bond price. However to simplify doing this calculation for yourself, you can use an established YTM calculator.

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The following example shows the YTM differences for a bond with the following characteristics, as calculated using a YTM calculator, for a bond priced at par, below par, and above par. Par Value Coupon Rate $1000 5%

Maturity 5 years

Par Value Bond Price $1000 $1000

Yield to Maturity 5%

$1000 $1000

6.19% 3.88%

$950 $1050

True Yield Although we’ve shown calculations for current yield and yield to maturity, the true measure of what you make on a bond includes other fees and costs. Without going into too much detail here, other fees and costs associated with purchasing a bond and that must be factored into a calculation of what you ultimately earn on a bond include: • Commission to bond dealer/broker for purchasing the bond • Accrued interest on next coupon payment - if you purchase a bond between coupon payments, you must pay the amount of interest accumulated towards the next coupon payment at the time that you purchase the bond. • Taxes

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