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There are four basic concepts that will help you
understand bonds:
-
Par value ? Par value, also known a face or
principal value, is how much the bondholder will receive at maturity. A
$1,000 par value bond will be worth $1,000 when it matures.
-
Coupon ? Coupon is the interest rate the bond
pays. It is called the coupon rate because bonds once came with a book of
coupons, which the holder had to clip and send in to receive an interest
payment. Bond investors are still referred to sometimes as ?coupon
clippers.? This interest rate does not vary over the life of the bond,
although there are some bonds, which have a variable interest rate tied to
an external index.
-
Maturity ? Maturity refers to the length of time
before the par value is returned to the bondholder. It may be as short as a
few months, 50 years, or more. At maturity, the bondholder receives the par
value of the bond.
-
Yield of the bond ? Explained in details as
below.
Understanding Yield
The term you will hear about bonds the most is their yield and it can be the
most confusing. I broke this concept out separately because there are really
three different types of yield to explain:
-
Nominal Yield ? This is the coupon or interest
rate. Nothing else is factored in to this number. It is actually not very
helpful.
-
Current Yield ? The current yield considers the
current market price of the bond, which may be different from the par value
and gives you a different return on that basis.
For example, if you bought a $1,000 par value bond with an annual coupon
rate of 6% ($1,000 x 0.06 = $60) on the open market for $800, your yield
would be 7.5% because you would still be earning the $60, but on $800 ($60 /
$800 = 7.5%) instead of $1,000.
-
Yield to Maturity ? Yield to Maturity is the
most complicated, but the most useful calculation. It considers the current
market price, the coupon rate, the time to maturity and assumes that
interest payments are reinvested at the bond?s coupon rate.
It is a very complicate calculation best done
with a computer program or programmable business calculator. However, when
you hear the media talking about a bond?s ?yield? it is usually this number
they are talking about.
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