When evaluating the potential performance of a bond, investors need to review certain variables. The most important aspects are the bond's price, its interest rate and yield, its date to maturity, and its redemption features. Analyzing these key components allows you to determine whether a bond is an appropriate investment.
- There are four key variables to be considered when evaluating a bond's potential performance.
- The bond's current price vis-a-vis its face value is one.
- The bond's maturity (the number of years or months the issuer is borrowing money for) is another variable.
- The bond's interest rate and its yield—its effective return, based on its price and face value—is a third factor.
- A final factor is redemption—whether the issuer can call the bond back in before its maturity date.
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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 it usually means the prevailing interest rates are lower than the rate the bond is paying. Hence, the bond trades at a higher amount than its face value, since you are entitled to a higher interest rate than you could get from comparable instruments.
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 amount at which the issuer will redeem the bond at maturity. This is also called the par value.
Interest Rate and Yield
A bond pays a certain rate of interest at periodic intervals until it matures. Bonds' interest rates, also known as the coupon rate, can be fixed, floating or only payable at maturity. The most common interest rate is a fixed rate until maturity; it's based on 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.
As their name implies, zero-coupon bonds don't pay any interest at all. Rather, they are sold at steep discounts to their face values. This discount reflects the aggregate sum of all the interest the bond would've paid until maturity.
Closely related to a bond's interest rate is its yield. The yield is the effective return earned by the bond, based on the price paid for the bond and the interest it generates. Yield on bonds is generally quoted as basis points (bps).
Two types of yield calculations exist. 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 price. The current yield does not account for the amount you will receive if you hold bond to maturity. The yield-to-maturity (YTM) is the total amount you will receive by holding the bond until the end of its lifespan 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—that is, demand that investors surrender it, in return for a payoff.
When interest rates rise, bond prices fall. Conversely, when interest rates fall, bond prices rise.
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 invest your money elsewhere, probably at a lower interest rate (a decline in interest rates is usually what triggers a call provision). To compensate you for taking on this chance, the bond pays more interest.