A prudent investor who does their homework can be comfortable in their investment in bonds and earn a nice return on their investment. Bonds can be a stabilizing and income producing element in a portfolio.
A bond is a debt contract with a company or public institution. The bond issuer needs money and will pay interest to borrow money for a defined amount of time. At the end of that time, the bond issuer is contractually obligated to honor the debt. Often the bond issuer has the option to recall the bonds earlier.
Bonds are for a specific value called face value or par and pay a flat amount of interest. That face value or par value of the bond does not fluctuate; printed on the “face” of the bond certificate. When a bond is issued, it is called the primary or first market. That is the only time the bond issuer is involved in the transfer. A common example is buying a US savings bond.
Not all bond holders keep the bond until it matures or is recalled. The bond then is bought or sold on the bond market or secondary market where the price fluctuates based on the interest environment.
If the interest rate the bond is paying is higher than the interest rate currently available, the bond will sell at a premium. Consider a $10,000 Bond may be paying 7% interest compared to money market accounts paying 6% interest the bond is more attractive so will sell at a premium price such as $11K. The bond holder will earn $100 more interest a year over the money market return.
If interest rate available is higher than the bond, the bond is valued less and sold at a discount. So if interest rates are at 8%, the 7% bond is below the market rates so it might sell for $9,000 instead of $10,000. Remember upon maturity, the bond issuer will honor the $10,000 face value regardless of purchase price.
Bond pricing is a see saw – interest rates on one end and bond price on the other. If the market interest rate is up, higher than the bond’s rate, then the bond’s price will be down, discounted. If the market interest rate is lower, then the price of the bond will be up at a premium.
The bond’s price in the secondary market determines the bond’s profitability which is also called the bond’s yield.
First, calculate the interest left to be paid on the bond – Interest rate times face value times years to maturity. So in our example 7% X $10,000 X 7 years equals $4,900 interest earned. Then add the discount ( Face value purchase price).
So for the discounted bond – (7% X 10K * 7 Years) +1K / (9 K* 7 year) X 100 = 9.36 % average interest yield per year. With market rates being 8% that is an attractive bond at the discount.
The formula for a premium bond:
% Yield to Maturity = (Interest rate X Face Value X Years to Maturity)-Premium X 100
Divided by
Bond price paid X Years to Maturity
(.07 X 10K X 7)- 1K/(11K X 7) X 100 = ($4,900 – $1K Premium)/ 77K = 5.06 %
With the premium price considered, this 7% bond is at a lower yield, 5.06 %, than what is available elsewhere at 6%. That is why one must calculate yield considering time to maturity or potential recall. If this bond was recalled in 5 years, the yield drops to 3.25%, a substantial difference.
This is an article for information purposes solely and is neither a solicitation nor a recommendation for investing.