If you’re thinking about investing in bonds, one of the first things you should do is make sure you are given the key bond information needed to decide whether you want to buy that particular bond. Your broker should have that information, especially the “CUSIP” number so you can do some extra research online. (If they don’t have that, get another broker.)
Kind of like a second opinion, even if you trust your broker, take the time to look it up to check out the info given, and also to see what good ole some online snooping tells you about those bonds and the issuing company. The “CUSIP” number will help you look up the bond issue you’re considering. Also, remember to look for any company financial news.
…is the percent of return (like an interest rate) that you will get from the bond you’re buying, regardless of what you pay. The yield reflects current market conditions and interest rates that have already been factored into the price. So the bond’s yield is, in effect, the extra money you’ll receive regularly as a percent of the exact amount of money you invested.
Note: Bonds can be bought newly-issued or “second hand” from the current owner. The price you pay for an already-issued bond is usually higher [premium] or lower [discount] than the face value or “par” at which the bond was originally issued, usually in increments of $1,000. But, as is happening at present with downward pressure on interest rates, even some newly-issued bonds can sell at a premium (higher than par value) to accommodate the lower rates. It’s just the way the math works.
A lower “yield to maturity” means that when the bond finally matures, you’ll only get back the original par value, even if you paid a higher price to buy the bond. Again, it’s about what current market conditions think is a fair price for the type of bond you are buying, setting the price for older bonds to match what similar newly-issued bonds are yielding. (BOND FACT: as a bond yield goes higher, the bond price goes lower. And vice versa. Again, it’s just the way the math works.)
… is the interest rate at which the bond is issued. Unlike the yield, this never changes. If a bond is used at a 3% coupon, that is the amount (based on the $1,000 per unit par value of the bond) that you will always receive, usually semi-annually.
Even if the bond price goes drastically up or down, your payment amount will stay the same. Just the yield (amount you get based on the current value of the bond) will vary. That’s why many retirees like having bonds; they count on the steady income — based on the coupon rate.
Of course, if they have to sell the bonds before they mature, then they may not get back what they invested if rates have gone up and therefore prices have come down. But by holding them to maturity, if at all possible, you are guaranteed to get back the face (par) value of the bonds when issued.
EXAMPLE OF YIELD VS COUPON CALCULATION
Let’s say you buy 5 units ($1000 per unit) of a 10-year bond that was issued two years ago with a coupon (issue interest rate) of 3%. The current price of the bonds is now $1020 per unit. Since the price is higher, at the very least we know the current yield will be lower. And when we do the calculation for what the yield is at this moment, it comes out to 2.94%.
To summarize the numbers: You paid $5,100 for 5 units of this bond. Your bond has eight years to go, during which time you will get a 2.94% yield (interest payment) twice a year. When the bond matures, you’ll receive $5,000 in cash. Your total earnings from that bond will be $1200 in interest payments minus the extra premium of $100 that you paid when you bought it.
So your Total Return (net profit) will be $1100 which is actually closer to about a 2.7% effective yield to maturity on your money over the 8 years you owned it. (We’ll save tax implications and actual price paid if bought between coupon payments for another day.)
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