You need to understand 5 basic concepts before you consider investing in bonds. The 5 elements of a bond investment are:
Coupon - Maturity Date - Price - Yield – Amount
Let’s start with an example of a generic California State General Obligation bond with the following coupon and maturity date:
Coupon: 5% – Maturity Date: July 1, 2020
Let’s say you are considering buying $10,000 worth of these bonds. $10,000 is the amount. This is also known as the par value or face value of the bonds.
Coupon. Coupon is the interest that the bond pays on annual basis. These California bonds pay a coupon of 5%; you will get $500 in annual interest. The coupon is a fixed rate of interest that the issuer will pay you until maturity. (With munis, the interest payment is made twice per year. You will get $250 every 6 months.)
Maturity. This is the date when the issuer redeems the bonds and pays you the face value of the bonds. These bonds mature on July 1, 2020. This means that on July 1, 2020, the state of California will pay you $10,000 upon maturity.
Amount, coupon, and maturity are simple enough. Price and Yield are much more complex concepts, but absolutely vital for you to understand fully. To start, coupon and maturity date are fixed elements. This means that whether I own the bonds, you own the bonds, or your neighbor owns the bonds, the state of California is going to pay anyone that owns these bonds 5% annual interest on $10,000 until July 1, 2020. At which point, it is going to pay $10,000 to the person that owns the bonds upon maturity.
Price and Yield are more complicated concepts to understand. These are not fixed elements meaning that the price of a bond and the yield of a bond change often. Price and yield fluctuate with market conditions.
Let’s start with PRICE: You know how during certain economic periods you hear about some distressed company’s bonds trading at 10 cents on the dollar. That’s how bonds are priced. They are basically priced in terms of cents on the dollar. To buy $10,000 of this fictitious company’s bonds, you would only pay $1,000 since it is trading at 10 cents on the dollar. The price of these bonds is 10: You can think of the price as 10 cents on the dollar or in percentage terms as 10% of the face value. When bonds have a price of 100, this is known as par: This is 100 cents on the dollar or 100% of the face value.
Now back to our California State bonds….
If these California municipal bonds have a price of 95, this means that to buy $10,000 of these bonds, it would cost you $9,500. On the maturity date of July 1, 2020, you would get $10,000, which is the face value.
This means that for these California Bonds:
Maturity Date: July 1, 2020
Now let’s understand the concept of YIELD. On $10,000 of these bonds, since the coupon is fixed at 5%, you will get $500 of annual interest regardless of what you paid for the bonds. Though you paid a price of 95 cents on the dollar for $10,000 of worth of bonds, you are still going to receive $500 of annual interest and get $10,000 at the maturity date of July 1, 2020.
Yield takes into account the following: You paid $9,500. You are going to receive $500 per year in interest, and get $10,000 back at maturity. $500 of annual interest on $9,500 is more than 5%. On top of that, upon maturity, you are going to get $10,000 back even though you only paid $9,500. Given these factors, provided you hold the bonds to maturity, your actual return or yield-to-maturity works out to considerably more than coupon rate of 5%. Yield is the number that accounts for these factors.
- Coupon: 5%
- Maturity Date: July 1, 2020
- Amount: $10,000
- Price: 95
= Yield: 5.7%
In this case, the yield works out to 5.7% (the bond mathematics used to derive the yield is not appropriate for our basic guide.)
When bonds are sold to you or offered to you, the offering yield is the most important number for you to know. This will be your actual return if you hold the bonds to maturity or until the issuer redeems the bonds.
As a general rule, if you pay less than a price of 100 for a bond, your actual return or yield will be higher than the fixed coupon rate.
We used the example of a bond trading at a discount because we felt it would be easier to explain the relationship between Price and Yield. In the current environment of 2011, most bonds trade a premium. This means that you have to pay more than 100 cents on the dollar for the bonds.
Just as mortgage interest rates fluctuate, rates on CDs and savings account fluctuate, so does the rates for municipal bonds.
On our California State bonds, let’s say that instead of the price being 95, the price was 105.
Maturity Date: July 1, 2020
In April 2011, if you paid a price of 105 for the California bonds above, this means that you would have paid $10,500 for bonds with a face value of $10,000. You will collect $500 per year until 2020 and upon the maturity date, you will get back $10,000. $500 of annual interest on $10,500 is less than 5%. On top of that, you are going to get back $10,000 upon maturity even though you paid $10,500. Over the next 9 years, you will have collected $4,500 in interest payments (9 times $500). Factoring in all this, your yield works out to 4.33% in this particular instance; this is your expected return if you hold the bonds to maturity.
- At a price of 95, this bond’s yield was 5.7%
- At a price of 105, this bond’s yield was 4.33% If you paid even more than 105 for the bonds, your yield will be even lower.
Take a breather. Make sure you understand the relationship between coupon, maturity, amount, price, and yield.