Owning Bonds

Unlike a stock, a bond's future cash returns are known with certainty. You know what the coupon will be (for a fixed-rate bond) and you know that at maturity the bond will return its face value. For example, if a bond pays a 4 percent coupon and matures in 2020, you know that every year your will receive $20 twice per year (20 = 4% × 1,000 × ½) until 2020 when you will also receive the $1,000 face value at maturity. You know what you will get and when you will get it. However, you can't be sure what that will be worth to you when you do. You don't know what your opportunity cost will be at the time.

Investment returns are quoted as an annual percentage of the amount invested, the rate of return. For a bond, that rate is the yield. Yield is expressed in two ways: the current yield and the yield to maturity. The current yield is a measure of your bond's rate of return in the short term, if you buy the bond today and keep it for one year. You can calculate the current yield by looking at the coupon for the year as a percentage of your investment or the current price, which is the market price of the bond.

current yield = annual coupon (interest received, or cash flows) ÷ market value =
(coupon rate × face value) ÷ market value.

So, if you bought a 4 percent coupon bond, which is selling for $960 today (its market value), and kept it for one year, the current yield would be 40 (annual coupon) ÷ 960 (market value) = 4.1667%. The idea of the current yield is to give you a quick look at your immediate returns (your return for the next year).

In contrast, the yield to maturity (YTM) is a measure of your return if you bought the bond and held it until maturity, waiting to claim the face value. That calculation is a bit more complicated, because it involves the relationship between time and value, since the yield is over the long term until the bond matures. You will find bond yield-to-maturity calculators online, and many financial calculators have the formulas preprogrammed.

To continue the example, if you buy a bond for $960 today (2010), you will get $20 every six months until 2020, when you will also get $1,000. Because you are buying the bond for less than its face value, your return will include all the coupon payments ($400 over 10 years) plus a gain of $40 (1,000 − 960 = 40). Over the time until maturity, the bond returns coupons plus a gain. Its yield to maturity is close to 4.5 percent.

Bond prices, their market values, have an inverse relationship to the yield to maturity. As the price goes down, the yield goes up, and as the price goes up, the yield goes down. This makes sense because the payout at maturity is fixed as the face value of the bond ($1,000). Thus, the only way a bond can have a higher rate of return is to have a lower price in the first place.

The yield to maturity is directly related to interest rates in general, so as interest rates increase, bond yields increase, and bond prices fall. As interest rates fall, bond yields fall, and bond prices increase. Figure 16.4 "Bond Prices, Bond Yields, and Interest Rates" shows these relationships.

Figure 16.4 Bond Prices, Bond Yields, and Interest Rates

You can use the yield to maturity to compare bonds to see how good they are at creating returns. This yield holds if you hold the bond until maturity, but you may sell the bond at any time. When you sell the bond before maturity, you may have a gain or a loss, since the market value of the bond may have increased or decreased since you bought it. That gain or loss would be part of your return along with the coupons you have received over the holding period, the period of time that you held the bond.

Your holding period yield is the annualized rate of return that you receive depending on how long you have held the bond, its gain or loss in market value, and the coupons you received in that period. For example, if you bought the bond for $960 and sold it again for $980 after two years, your return in dollars would be the coupons of $80 ($40 per year × 2 years) plus your gain of $20 ($980 − 960), relative to your original investment of $960. Your holding period yield would be close to 5.2 percent.