For example: A “make believe” company called Hi Five Corporation issues a short term two-year bond which has a face value of $1,000 and pays 5% Interest. The 5% represents the coupon rate. You would then earn $50 each year ($1,000 x .05 = $50) for 2 years for a total of $100 for the life of the bond.
Staying with the same example: since you are generally paid interest semi-annually (twice a year), and since the annual yield of Hi Five Corp., is $50 (5% of $1,000), the coupon payment would be $25 ($50 ÷ 2 = $25).
In our example: when the Hi Five Corporation originally issued their bonds, the going rate was 5%. A year later, bonds are now being issued with a 5.6% interest rate. In order to provide the same value to the buyer, you would have to offer a $100 discount on the $1,000 bond, bringing the bond price to $900. Since the coupon rate is fixed at 5% it still only pays $50 annually, but that divided into the market price of $900 versus the original price of $1,000, produces a current yield of $5.6% ($50 ÷ $900 = 5.6%), which would now equal that of the other bonds going to market.
If interest rates go down, you can demand a premium for your money (asking more than you paid for), to make up the difference in rates.
If, in the Hi Five Corporation example: interest rates go down to 4.5%, you can now ask for a premium of $100 for your $1,000 bond, bringing the market value to $1,100, which would bring a comparable yield of 4.5% ($50 ÷ $1,100 = 4.5%).
CURRENT YIELD
When the bond price is at par (original) |
$50=5.00% $1,000 |
When the bond price rises, its yield declines |
$50 = 4.54% (yield declined) $1,100 (bond price rises) |
When the bond price declines, the yield rises |
$50=5.56%(yield rises) $900 (bond price declined) |
In Our Example: Above we discussed Current Yield (Interest Rate (5%) ÷ Amount of the bond ($1,000 = $50). But in our Hi Five Corporation, the bond was for two years. A year had passed so the current yield was actually the yield to maturity. However, let’s say the bond was a five-year bond, with four years left to maturity, what then? Use any financial calculator such as (http://www.moneychimp.com/calculator/bond_yield_calculator.htm ) that will do this for you, or you can ask your broker.
Annual Accumulated Discount
÷ Number of years to maturity
+ Annual interest payment x 100 = Yield to Maturity (YTM)
Average of face value + Current price
We will use the example our High Five – Yield to Maturity with a Discounted ($100 Bond):
- Corporate Bond: Hi Five Corporation
- Term of Bond: 5 years
- Years to Maturity : 4 years
- Purchase Price: $900 (a $100 discount)
- Face Value: $1,000
- Annual Interest Payment: 5% or $50
First we know the interest is 5% per year, one year has passed on our 5 year bond which means we still have four years to go. We will receive $50 per year (5%), and another $100 when the bond matures, since we purchase the $1,000 Face Value Bond for $900 (remember it is $1,000 bond we purchased for $900 = $100).
I. Calculate the Annual Accumulated Discount
a. Discount Amount ÷ number of years to maturity
$100 (Discount Amount) ÷ 4 (# of years to maturity) = $25
Annual Accumulated Discount $25 ($100 discount ÷ by 4 years left) = $25 per year )
+ Plus $50 (Annual interest payment = $50) = $75 $25 + $50 = $75
II. Average of Face Value ($1,000 face value ) plus Current Price
($900 current price) ÷ by 2(average) = $950
$ 75 ($25 + $50) |
x 100 = 7.89% Yield to Maturity (YTM) |
$950 ($1,900 ÷ 2) |
CREDIT RATINGS |
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CREDIT RISK |
Moody's |
Standard & Poor’s |
Fitch |
INVESTMENT GRADE |
Aaa | AAA | AAA |
Highest Quality | Aa | AA | AA |
High Quality (very strong) | A | A | A |
Upper Medium Grade (strong) | Bba | BBB | BBB |
Medium Grade | |||
NOT INVESTMENT GRADE |
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Lower Medium Grade (somewhat speculative) | Ba | BB | BB |
Low Grade (speculative) | B | B | B |
Poor Quality (may default) | Caa | CCC | CCC |
Most Speculative | Ca | CC | CC |
No interest being paid or bankruptcy petition filed | C | C | |
Lower Medium Grade (somewhat speculative) | Ba | BB | BB |
In default | B | B | B |
Simplified Ratings | C | CCC | CCC |
These are bonds that can be swapped for the same company’s common stock at a fixed ratio, providing a specified amount of bonds for a specified number of shares of stock. The terms are outlined when the bond is issued. Some investors like the ability to convert since, IF the price of the stock rises enough you can profit by swapping your bonds for stock. However, Convertible Bonds are normally offered at a slightly lower rate than a regular bond, since you have the option to "convert" the bond to stock. If the stock price fails to rise or goes down, you will lose money on convertibles. Because convertible bonds can be converted to stocks, they tend to be more closely in sync with the stock market versus the bond market. These are very complicated securities.
INTERNATIONAL INFORMATION
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