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Chapter 8. Fixed Income Investments: Bui... > Bonds, Bonds, My Kingdom for a Bond

Bonds, Bonds, My Kingdom for a Bond

Since there are so many varieties of bonds to choose from, we have to pare them down into broader categories so that we can get our arms around them. I also want to provide you with a basic lesson on bond terms so that you have some background for our discussions on calculators and bond-price fluctuations. As an example, let's assume that Disney issues a 10-year corporate bond with a par value of $1,000 per bond, a coupon rate of 5 percent, and a maturity date of January 15, 2014. I'll use this example to provide any further explanation of terms:

  • Face amount. Also known as par value, this is the amount of money that the bond issuer will pay at the maturity date. If you buy the bond at face amount, you receive your money back at maturity. If you pay more than the face amount for the bond, you are paying a premium; if you pay less than the face amount, you're getting a discount. Bonds are almost always sold in $1,000 increments. The Disney bond has a par value of $1,000. If it were trading at a 10 percent premium, it would sell for $11,000. If it were trading at a 10 percent discount it would be trading at $9,000.

  • Maturity. This is the date that the bond matures. As you will hear from me repeatedly during this chapter, there are no maturity dates on bond funds, only on the bonds within the funds have maturity dates. Table 8-1 shows how maturities tie to the different classification of terms; that is, the types of time-specific bonds available for purchase. From this example we see that the Disney bond is a long-term bond.

    Table 8-1. Bond Maturity Terms
    Bond MaturityTerm
    1 to 3 yearsShort
    4 to 10 yearsIntermediate
    Over 10 yearsLong

  • Coupon. The coupon is interest that the issuer pays on the bond. Most bonds pay interest biannually, so if you have a $1,000 bond that pays 5 percent a year as the Disney bond does, you'll receive two checks for $25 each for every $1,000 you have invested in the bond.

  • Current yield. The yield is a little more complex of an element to understand. Theoretically, if you purchase the bond at face value and the valuation for the bond remains constant, the yield and the coupon are the same thing. Realistically, though, the bond value will fluctuate with interest rates and with the rating of the issuer. The current yield adjusts to these conditions by going up or going down. As interests and/or credit risk escalate, the price of the bond goes down and so does the current yield. Conversely, as interest rates go down and/or the credit risk lessens, the yield goes up.

  • Yield to maturity(YTM). This calculates the principal plus the reinvestment of the income at some assumed rate and provides the total projected yield. YTM is used to compare the value of bonds with different issue and maturity dates, coupon rates, and par values. If you are able to reinvest the money you receive from Disney at 4 percent, your YTM would be 4.87 percent before taxes. If you were able to reinvest at 6 percent, your YTM would be 5.29 percent before taxes.

  • Duration. The duration of a bond adjusts the amount of time it takes to return principal and interest based on changes in interest rates. If interest rates don't change at all during the term of the bond, duration will equal the maturity date. But since that rarely happens, the duration will increase or decrease depending on the impact that interest rates have on the bond.

  • Yield to call. Most bonds have a call date. A call date is a time or a number of times over the course of the bond's life that the issuer can redeem the bond at face value. If your bond has a call provision, you may want to calculate your yield to call. This is the yield on the investment to the first possible call date. Bonds are typically called because of reductions in interest rates or the improved credit rating of the issuer. Let's say that the Disney bond has a right to call at 36 months, but Disney has to pay you 115 percent of the face value. Assuming we have been able to reinvest at the same 5 percent as the bond, your yield to call would be 8.69 percent before taxes.



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