Bonds

 

Bond Terminology

When you get a bond from a government or a company, you get a piece of paper called a bond certificate.  Note: in the new electronic age you might not get a real piece of paper.  On the bond are various numbers which spell out the terms.  It will say who is borrowing the money; for how much; when the bond issuer will repay the money; and how much interest they will pay.  Bonds have their own terminology and you need to understand them if you want to invest in bonds.  Be careful of the word YIELD, based on the context and the word before yield, it can mean various things.  There are four types of yields: Coupon Yield, Current Yield, Yield to Maturity, and Call Yield.


  • Face Value/Par/Principal Amount:  This shows the amount of money you lent the issuer (say $1,000) that they will repay you when the bond matures.  Whoever the investor is at the time of maturity (since bonds can be sold before the maturity date) will receive the face value (principal) for it.  Bonds are usually set in $1,000 denominations.
  • Maturity Date:  The bond expires on the maturity date (when it comes due).  This is the latest date by which the issuer must repay the loan to the bondholder.  This can be from one year or less, to more than 30 years.
  • Term of the Bond:  The amount of time from the day the bond is issued to the day it expires is called the Term of the Bond.  This can be any length of time up to 30 years or more.  Bonds can be further classified into groups with similar time lengths (these are general time specifications;  there is no definitive definition) such as:
    • Ultra Short Term:   Bonds that mature in one year or less
    • Short Term:  Bonds that mature from one to five years
    • Intermediate Term:  Bonds that mature from  five to 10 years
    • Long Term:  Bonds that mature from 10 to 30 years or more
       
  • Coupon Rate/ Coupon Yield/Fixed Interest Payment:   This is the interest rate that the issuer is paying based on the face value of the bond.  A coupon is set at the time the bond is issued and, for most bonds, stays the same until maturity.  In years past, almost all bond certificates came with coupons attached.  Years ago, people use to clip the coupons (every six months= 2 per year) and present them for payment.  This is where the term Coupon Rate came from; it is now known as yield or fixed interest payment.  The coupon Rate is the annual payment expressed as a percentage of the bond’s face-value.

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.

  • Coupon Payment:  This is how much money in dollars will be paid at every interest period, every 6 months (2 x a year) (versus yield which is stated as a percentage).

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).

  • Current Yield:  This is the annual interest payment calculated as a percentage of the bond’s current market price.  Bond prices can go up or down based on current interest rates.  Bond prices change over the life of the bond, although the bondholder receives full face value at maturity.  If all other factors are equal, an investor would never buy an existing bond from another bondholder when new comparable issued bonds are being offered elsewhere at a higher return.  On the other hand, if interest rates go down, a bondholder would demand more money for a bond with a higher yield.  The term “current yield” really explains how bond prices change.  However, the more important term to long term bond holders is "yield to maturity" (explained below).

    If interest rates go up, you have to offer your bond at a discount to make sure the yield is equal to the current offerings.

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)

 

  • Yield to Maturity (YTM)/Redemption Yield:  This is used to determine the rate of return an investor would get if a bond (or any long term investment) is held until maturity, assuming all coupons and principal payments will be made and that the coupon payments are reinvested in the bond’s promised yield.  When a bond first comes out, the bond’s yield is equal to its current yield or coupon rate.  But if you purchase it at a later date, it might be at a premium (where you pay more) or at a discount (where you pay less).  YTM is usually presented in terms of Annual Percentage Rate (APR).  The yield of a bond is measured by the income it generates. Yield is calculated as the amount of interest paid on a bond divided by the price.


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.

 

  • ADVANCED – Yield To Maturity Calculation (YTM):  But if you really want to know the approximate YTM (does not include re-investment), here is the basic math.

 


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)