What to Do
Bonds tend to be issued in multiples of $1,000. Bond yield is calculated as a percentage of the bond value.
Example:
Suppose an investor is buying $4,000 in new $1,000 10-year bonds, with an annual interest rate of 5%. To work out the bond yield, the face value ($4,000) is multiplied by the stated rate of interest (5%, or 0.05):
So the annual yield is $200. Where interest is paid twice a year, the investor receives $100 every six months for the duration of the bond (10 years). Over the course of the investment they will earn $2,000 in interest, plus their original investment—which they get back at the end (“maturity”). In this case the bond was new when purchased, so the 5% is also called the “yield to maturity.”
This basic formula is very simple, but it can be modified to illustrate various factors such as depreciation of the dollar over the period of investment. A more sophisticated calculation will predict the value of the yield taking this into account. In addition, fluctuating interest rates will affect bond yields and the trading environment. Once a bond is bought, the interest is fixed, but the price of new bonds will reflect changes in the market.
What You Need to Know
- Bond issuers can redeem or “call” the bond before it matures, at an agreed time and price (the “yield-to-call” rate). This is most common if interest rates fall; new bonds will then be issued at a lower rate. The yield-to-call rate is often more realistic than the actual bond yield as an indicator of expected return.
- Investors should understand that there are different kinds of bond. Some are backed by assets (“asset-backed securities”); some invest in the U.S. treasury (“government bonds”—considered among the safest possible investments); and others, such as “high yield bonds,” tend to be riskier.
- Zero coupon bonds pay no interest at all, but investors buy them at a fraction of their face value. For example, a 20-year bond with a face value of $15,000 might be sold for just $5,000. The value of the bond increases until maturity—20 years later—when the investor gets the face value of the bond (“par value”), and makes $10,000. Zero coupon bonds carry some risk because their actual value is diminished by rising interest rates.
- When interest rates rise, the value of existing bonds falls because new bonds are being issued that pay a better rate. The reverse is also true.
Where to Learn More
Web Site:
The Motley Fool: www.fool.com
