Investing in bonds seems fairly straightforward. Buy a bond with a fixed coupon rate, collect the interest twice a year and get par value back at maturity. What’s more to know? While that is a good description of the mechanics of a bond investment, for many investors class begins when talking about the return earned.
Bond Market 101
The investment return is a function of the fixed coupon rate and the price paid for the bond. Generally, new bonds come to market with a coupon rate that reflects the current interest rate environment and are priced at par. Par value is $1000 and equates to the value of the bond at maturity. Today, a current coupon rate for a 10-year municipal bond would be 4.5 percent. Buying the current issue, paying par value, the investor receives 4.5% in interest on a semi-annual basis and par value back at maturity. The investor earns a 4.5% return.
Bond Market 201
If the investor is looking at a bond issued when interest rates were higher, say 5.0%, the seller would not let it go for only par when coupons today are 4.5 percent. In fact, the seller expects to be made whole and requires a premium that brings the return in line with the current interest rate environment. In our example, the 5% coupon bond would sell for $1040. The combination of the above market coupon and the reduction in principal value over the remaining life of the bond equates to a return of 4.5%.
Discount bonds represent the other side of the spectrum. If a bond was issued with a coupon below current rates, say 3.0%, par would again not be a fair price. The investor would demand a discount on the price to make up for the below market coupon rate. Again using our example, the 3.0% coupon would sell for $880. The combination of the below market coupon and the increase in principal value over the remaining life of the bond equates to a yield to maturity of 4.5%.
Bond Market 301
The measure of a bond’s return is the yield to maturity (YTM). It is the common denominator that allows investors to compare bonds of various coupons and maturities. Bonds with similar maturities will not necessarily trade at the same YTM. An issuer’s credit quality, of course will impact the bond’s YTM. Investors expect to earn higher returns on bonds with below average credit quality. Bonds that are priced either at a discount or at a premium to par will also trade at higher than average yields to maturity.
Bond Market 401
Many bond buyers fail to get their diploma and cannot understand why anyone would buy a bond priced above par when they will only receive par at maturity. Discount bonds have an even greater stigma. Investors interested in income do not want a bond with a below average coupon. The greater the premium or discount, the more sellers must entice buyers by offering them above average yields to maturity. So, buyers armed with a B.S. in bonds can pick up some pretty good bargains.
