Independent credit rating services assess the default risk, or credit risk, of bond issuers and publish credit ratings that not only help investors evaluate risk, but also help determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer.
Yield is therefore based on the purchase price of the bond as well as the coupon. When prevailing interest rates fall — notably, rates on government bonds — older bonds of all types become more valuable because they were sold in a higher interest rate environment and therefore have higher coupons.
The easiest way to understand bond prices is to add a zero to the price quoted in the market. Most bonds are issued slightly below par and can then trade in the secondary market above or below par, depending on interest rate, credit or other factors. Put simply, when interest rates are rising, new bonds will pay investors higher interest rates than old ones, so old bonds tend to drop in price. Falling interest rates, however, mean that older bonds are paying higher interest rates than new bonds, and therefore, older bonds tend to sell at premiums in the market.
On a short-term basis, falling interest rates can boost the value of bonds in a portfolio and rising rates may hurt their value.
Conversely, in a falling interest rate environment, money from maturing bonds may need to be reinvested in new bonds that pay lower rates, potentially lowering longer-term returns. The inverse relationship between price and yield is crucial to understanding value in bonds.
Duration, like the maturity of the bond, is expressed in years, but as the illustration shows, it is typically less than the maturity. For a zero-coupon bond, maturity and duration are equal since there are no regular coupon payments and all cash flows occur at maturity. Because of this feature, zero-coupon bonds tend to provide the most price movement for a given change in interest rates, which can make zero-coupon bonds attractive to investors expecting a decline in rates.
The end result of the duration calculation, which is unique to each bond, is a risk measure that allows investors to compare bonds with different maturities, coupons and face values on an apples-to-apples basis. Duration provides the approximate change in price that any given bond will experience in the event of a basis-point one percentage point change in interest rates.
The weighted average duration can also be calculated for an entire bond portfolio, based on the durations of the individual bonds in the portfolio. Since governments began to issue bonds more frequently in the early twentieth century and gave rise to the modern bond market, investors have purchased bonds for several reasons: capital preservation, income, diversification and as a potential hedge against economic weakness or deflation.
When the bond market became larger and more diverse in the s and s, bonds began to undergo greater and more frequent price changes and many investors began to trade bonds, taking advantage of another potential benefit: price, or capital, appreciation.
Today, investors may choose to buy bonds for any or all of these reasons. Capital preservation : Unlike equities, bonds should repay principal at a specified date, or maturity.
This makes bonds appealing to investors who do not want to risk losing capital and to those who must meet a liability at a particular time in the future. Bonds have the added benefit of offering interest at a set rate that is often higher than short-term savings rates. On a set schedule, whether quarterly, twice a year or annually, the bond issuer sends the bondholder an interest payment, which can be spent or reinvested in other bonds.
Stocks can also provide income through dividend payments, but dividends tend to be smaller than bond coupon payments, and companies make dividend payments at their discretion, while bond issuers are obligated to make coupon payments. Capital appreciation : Bond prices can rise for several reasons, including a drop in interest rates and an improvement in the credit standing of the issuer. However, by selling bonds after they have risen in price — and before maturity — investors can realize price appreciation, also known as capital appreciation, on bonds.
Capturing the capital appreciation on bonds increases their total return, which is the combination of income and capital appreciation. Investing for total return has become one of the most widely used bond strategies over the past 40 years. Diversification : Including bonds in an investment portfolio can help diversify the portfolio. Many investors diversify among a wide variety of assets, from equities and bonds to commodities and alternative investments, in an effort to reduce the risk of low, or even negative, returns on their portfolios.
Potential hedge against an economic slowdown or deflation : Bonds can help protect investors against an economic slowdown for several reasons. The price of a bond depends on how much investors value the income the bond provides. A discount bond, in contrast, has a coupon rate lower than the prevailing interest rate for that bond maturity and credit quality.
An example may clarify this distinction. Because of this bidding-up process, your bond will trade at a premium to its par value. Your buyer will pay more to purchase the bond, and the premium they pay will reduce the yield to maturity of the bond so that it is in line with what is currently being offered. On the other hand, a bond discount would enhance, rather than reduce, its yield to maturity.
YTW gives the investor the lowest possible yield that a bond can produce without going into default. The principal is also paid back at this time. There is more going on with bonds than this simple scenario. Bonds can become premium or discount bonds. They could trade above or below their par value while bond traders attempt to make money trading these yet-to-mature bonds. A premium bond trades above its issue price.
This is called its par value. A discount bond does the opposite. It trades below par value. From the time they are issued until they mature, bonds trade in the open market, just like stocks. As a result, their prices can rise above par or fall below it as the market's ups and downs dictate. When a bond is first issued, it has a stated coupon. The current yield is the rate of return on a bond. The trade yield changes to a current yield of 2.
Keep in mind that prices and yields move in opposite directions. Prevailing interest rates are always changing. Existing bonds adjust in price so that their yield when they mature equals or very nearly equals the yields to maturity on the new bonds being issued.
Many investors confuse YTM with current yield. Yield to maturity YTM is the speculated rate of return of a bond held until maturity.
Finding YTM is much more involved than finding current yield. This is a simplified way of looking at a bond's price, as many other factors are involved; however, it does show the general relationship between bonds and interest rates. As for the attractiveness of the investment, you can't determine whether a bond is a good investment solely based on whether it is selling at a premium or a discount. Many other factors should affect this decision, such as the expectation of interest rates and the credit worthiness of the bond itself.
If a bond is trading at a premium, this simply means it is selling for more than its face value. Bond investments should be evaluated in the context of expected future short and long-term interest rates, whether the interest rate is adequate given the bond's relative default risk, expected inflation, bond duration interest rate risk associated with the length of the bond term and price sensitivity relative to changes in the yield curve.
In the end, anything with the potential to impact cash flows on the bond, as well as its risk-adjusted return profile, should be evaluated relative to potential investment alternatives. Fixed Income Essentials. Financial Analysis. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
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