Bonds: Key terms & concepts of Bonds
Coupon Yield - The coupon yield
is the interest rate that the issuer of a bond or other debt security promises
to pay during the term of a loan. For example, a bond that is paying 6% annual
interest has a coupon rate of 6%. The term is derived from the practice, now
discontinued, of issuing bonds with detachable coupons. To collect a scheduled
interest payment, you presented a coupon to the issuer or the issuer's agent.
Today, coupon bonds are no longer issued. Most bonds are registered, and
interest is paid by check or electronic transfer.
Current Yield - Current yield is the return you
actually earn on the bond and it is based on the price you paid and the
interest payment you receive. There are basically two types of bond yields you
should be aware of: current yield and yield to maturity or yield to call.
Current yield is the annual return on the dollar amount paid for the bond and
is derived by dividing the bond's interest payment by its purchase price. If
the price you pay for a bond is higher or lower than par value (face value),
the yield will be different from the interest rate. For example, if you bought
at $1,000 (par) and the interest rate is 6% ($60), the current yield is 6%
($60 ÷ $1,000). If you pay $950 (discount) for the same bond, your yield is
6.3% ($60 ÷ $950 = 0.0631). But if you paid $1,100 (premium) for the bond,
your yield would be only 5.5% ($60 ÷ $1,100 = 0.0545). So, the yield on your
investment and the interest rate your investment pays are sometimes, but not
always the same. It's also important to note that yield is not a true return
measure because it does not account for capital gains or losses.
Yield to maturity (YTM) is the most precise measure
of a bond's anticipated return. YTM is the current yield plus the capital gain
or loss you can expect if you hold the bond to maturity. For example, if you
pay $700 for a 6% coupon bond with a face value of $1,000 maturing 10
years from the date of purchase, you will earn not only the $60 a year in
interest but also another $300 when it matures. Of course, you can sell a bond
to another investor before it reaches maturity. YTM takes into account the interest rate in
relation to the price, the purchase or discount price in relation to the par
value, and the years remaining until the bond matures. Although YTM figures
are complex to calculate, brokers will supply this information if you ask, or
you can use a online calculator programmed to provide YTM figures at
prenhall.com.
Yield to call is the same as yield to maturity,
except it is calculated on the assumption that the bond will be redeemed on
the first possible call date. It's the rate of return that an investor would
earn if he bought a callable bond at its current market price and held it
until the call date.
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What is a callable bond?
Many bonds, especially those issued by corporations, are
callable. This means that the issuer of the bond can redeem the bond prior to
maturity by paying the call price, which is greater than the face value of the
bond, to the bondholder. Often, callable bonds cannot be called until 5 or 10
years after they were issued. When this is the case, the bonds are said to be
call protected. The date when the bonds can be called is known
as the call date. |
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Key concepts of
Bonds
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