You need to review certain variables when evaluating the potential performance of a bond. The most important aspects in evaluating bond performance are the price of the bond, the interest rate and yield, the maturity and the redemption features. Analyzing these key components allows you to determine whether a bond is an appropriate investment.
The first consideration is the price of the bond. The yield that you will receive on the bond impacts the pricing. Bonds trade at a premium, at a discount or at par. If a bond is trading at a premium to its face value, then the prevailing interest rates are lower than the yield the bond is paying. Hence, the bond trades at a higher amount than its face value, since you are entitled to the higher interest rate.
A bond is trading at a discount if the price is lower than its face value. This indicates the bond is paying a lower interest rate than the prevailing interest rate in the market. Since you can obtain a higher interest rate easily by investing in other fixed income securities, there is less demand for a bond with a lower interest rate. A bond with a price at par is trading at its face value. The par value is the value at which the issuer will redeem the bond at maturity.
Interest Rate and Yield
A bond pays a fixed rate of interest until it matures, which is the bond’s interest rate. The interest rate can be fixed, floating or only payable at maturity. The most common interest rate is a fixed rate until maturity that is a portion of the bond’s face value. Some issuers sell floating rate bonds that reset the interest based on a benchmark such as Treasury bills or LIBOR. Bonds that only make an interest payment upon maturity are called zero-coupon bonds. They are sold at discounts to their face values.
A bond's yield is closely related to the interest rate. The yield is the return earned based on the price paid for the bond and the interest received. Yield on bonds is generally quoted as basis points (bps). There are two types of yield calculations used. The current yield is the annual return on the total amount paid for the bond. It is calculated by dividing the interest rate by the purchase prices. The current yield does not account for the amount you will receive if you hold bond to maturity.
The yield to maturity is the total amount you will receive by holding the bond until it matures. The yield to maturity allows for the comparison of different bonds with varying maturities and interest rates. For bonds that have redemption provisions, there is the yield to call, which calculates the yield until the issuer can call the bond.
The maturity of a bond is the future date at which your principal will be repaid. Bonds generally have maturities of anywhere from one to 30 years. Short-term bonds have maturities of one to five years. Medium-term bonds have maturities of five to 12 years. Long-term bonds have maturities greater than 12 years.
The maturity of a bond is important when considering interest rate risk. Interest rate risk is the amount a bond’s price will rise or fall with a decrease or increase in interest rates. If a bond has a longer maturity, it also has a greater interest rate risk.
Some bonds allow the issuer to redeem the bond prior to the date of maturity. This allows the issuer to refinance its debt if interest rates fall. A call provision allows the issuer to redeem the bond at a specific price at a date before maturity. A put provision allows you to sell it back to the issuer at a specified price prior to maturity.
A call provision often pays a higher interest rate. If you hold such a bond, you are taking on additional risk that the bond will be redeemed and you will be forced to reinvest at a lower interest rate.