A Bond is a simple financial instrument. The investor - or lender - loans money to a borrower (typically a company or government) for some specific or general purpose. The borrower is contractually obligated to pay the lender some agreed upon periodic payment (called a coupon) and then return their original investment at maturity. The only way this schedule of payments would not occur is through a default (a bankruptcy, for example) or a re-negotiation of the loan terms.
If the structure of the investment is so simple and an investor knows in advance what payments can be expected, why are people often confused by bonds and the way a bond’s price fluctuates? There are three primary reasons:
1) People often fail to realize that bonds identical to the one they own can be freely traded in the market and are therefore subject to price fluctuations. This is called the secondary market. If you don’t plan to sell the bond before it matures and the company or government does not default on its debt, none of this will matter much. But if you do need to sell the bond before maturity, you can make or lose money on the investment.
The bond that you own has coupon payments and a maturity date that is set in the original agreement and is subject to a schedule of payments as explained above. But between the day the bond is issued and the day the bond matures, a lot can - and often does - happen.
For example, maybe a company had a couple of great years and is on more sound financial footing than it was when the bond was issued. The company is now more likely to be able to pay the bondholder his or her interest and principal, meaning the investment is now of higher quality and has likely increased in value. Alternatively, maybe the company had some tough years and is finding it more difficult to pay the bondholder back his or her money. This bond is now riskier and is less valuable than it used to be because the likelihood that the company will default on its payments has gone up.
2) Unlike stocks which usually trade on an exchange, bonds in the secondary market are typically bought and sold “over the counter”, meaning they are traded privately between large broker-dealers, banks, investment funds, and other entities. If you want to know the price of the Apple stock you own, you can just type the stock’s ticker symbol into Google, Yahoo Finance, your brokerage firm’s website, or see it scrolling on the bottom of the TV screen on any financial news network. If you want to know the price of the Apple bond you own, good luck. It is not a secret, but the information is far less accessible.
3) The metrics people often use to describe the relative value of a bond are numerous and confusing. The price of a bond will change in the secondary market based on the interest rate that was in place when you bought the bond vs the interest rate someone would require now due to changes in the company’s financials, the economy, investor preferences, and many other factors. If the bond you own pays more interest than a comparable newly issued bond, its price will increase and vice versa. Without delving into the relatively standardized credit ratings a bond can have, we explain below a few of the metrics people quote when describing the value or return you can expect from a bond bought in the secondary market…
Nominal Yield is the coupon rate of a bond, typically referenced for newly issued bonds. If you loan a company $1,000 (the bond has a $1,000 face value) and the company will pay you $50 annually, the bond has a nominal yield of 5% ($50 / $1,000 = 0.05 = 5%).
Current Yield is the yield referred to for a bond trading on the secondary market. Lets say the $1,000 bond you own could now be bought for $900 on the secondary market because the company is going through tough times. The $50 interest payment is fixed so if someone buys that bond from you, that investor’s bond has a current yield of 5.55% ($50 / $900 = 0.055 = 5.55%). Notice that the yield has gone up because the investor is receiving the same interest but bought the bond at a $100 discount.
Yield to Maturity is a measure of the bond’s annual rate of return if it is held to maturity. This is probably the most referenced metric in the bond world. It assumes all coupon payments are made and principal is returned at maturity and will fluctuate based on the bond’s current price and the number of years until the bond matures.
The 30 Day SEC Yield is only used when looking at a fund that owns numerous bonds. It is calculated by dividing the fund’s net income per share over the last 30 days (income after deducting expenses) by the fund’s price per share on the last day of that 30 day period, It is used as an indication of how much yield an investor can expect over the next 12 months assuming the fund earns the same yield for the rest of the year, which will not always be the case.
As you can see, there are numerous metrics an investor can look at to assess how their bond or bond fund is changing in value. It makes a simple financial instrument more complicated. This is not necessarily a bad thing because it allows investors to analyze a bond in real time while taking into account the changes that occur between the day a bond is issued and the day it matures.
This is for educational purposes only. To learn more about the topics mentioned and if they are suitable for you, consult an appropriate professional. Tax laws can change at any time.
Any information provided in this presentation has been prepared from sources believed to be reliable, but is not guaranteed and is not a complete summary or statement of all available data necessary for making an investment decision. Any information provided is for information purposes only and does not constitute a recommendation.
Arthur Stein and Arthur Stein Financial, LLC are not authorized to give legal or tax advice. For information on your specific situation, please consult your tax advisor regarding any tax implications and your attorney for legal implications. As required by the US Treasury Regulations, you should be aware that this presentation is not intended to be used and it cannot be used for the purposes of avoiding penalties under federal tax laws.
Keep in mind that:
Past performance is no guarantee of future performance;
Investments involve the risk of loss of principal and earnings;
ETFs, mutual funds, money market funds, etc. are not guaranteed by the US Government, the FDIC, a bank or anyone else.
“Average annual return” evens out variations in the actual year-to-year returns.
ETFs, mutual funds and individual stocks and bonds fluctuate in value and there will always be times when they lose value.
None of the information provided is necessarily relevant to anyone’s personal situation. Circumstances differ among individuals and you should not assume that these generalizations or information apply to you.
Investments mentioned may not be suitable for all investors.