Understanding Bonds

The world of Bonds is certainly an interesting one. While many investors see bonds as less volatile than riskier equities, there are bond-specific risks (and opportunities) that investors should be aware of. We look at the idea of Yield here, by understanding two key areas of return for bond holders.

Coupon
The Coupon on a bond is simply the income it generates. Since bonds are normally denominated in thousand dollar increments (e.g. \$100,000) a 5% coupon is easy to figure out as \$5,000. The math is simple: \$100,000 X 0.05 = 5,000.

The coupon rate is important for a couple of reasons. First, it tells the investor how much income he or she can expect from holding the bond. Regardless of what happens to the value of that bond on a day-to-day basis, the income will always be the coupon rate (or \$5,000 in this example).

And yes, the value of the bond will fluctuate based on a host of factors, but the most important for a lot of investors is the interest rate factor. As rates increase for bonds, the market value of the bond will drop. This is because if rates went from 5% to 6%, any investor who needs to generate fixed income would be better off buying a new issue than buying your “second-hand” bond on the open market. To attract this investor, you would have to reduce the price for your bond so that, even though the income is just \$5,000, if the bond holder keeps your bond to maturity, the \$1,000 shortfall over the years is more than made up. (Of course, this is simplified).

Maturity Date
Like term deposits, bonds come due at a specific time in the future. At that time, the bond issuer will repay the face value of the bond (the value in thousands, like \$100,000) regardless of what has happened to the “value” in the open market over the years.

For this reason, bonds make for safe investments provided that the issuing company has the means to repay them at maturity.

Yield
Yield is what the investor will earn on the bond given the market value and income (coupon). For this reason, bonds that are market valued below the face value (e.g. \$95,000) and generate less income than current bonds being issued (e.g. \$5,000 instead of \$6,000), can yield the same returns as current bonds. The big difference is that bonds selling at discounts will come with a capital gain (or loss if the value is higher than the face, or maturity value).

Summary
It becomes difficult to find great “deals” in the bond market since most brokers or traders will have a slight edge over everyday investors. But the good news is that even current-issue bonds will generally yield the same as bonds that have been around for a while (e.g. if you are looking for a 20 year bond, you could look at a 30 year bond that has already been around for 10 years and will generally yield the same).

Depending on the investors needs (income versus capital gains versus capital losses, etc.), bonds provides a great deal of flexibility.