Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 33)

Bonds (part C)

by

Charles Lamson

What's a Bond Worth?

One of the problems with bonds is the language and math used to describe how they work and are traded. So let us jump right in and get a handle on common bond terminology and math.

Bonds, like stocks, are sold on two venues. The first is at original issue and the second is in the secondary market.

Original Issue

When a bond is issued, it is at par value. Since most bonds are issued in $1,000 denominations, the par value is $1,000. The bond is also issued at a fixed interest rate, or coupon rate. The bond also has a maturity date, which is the day when the bond must be paid in full.

For example, XYZ Corp. might issue 10-year bond with an interest rate of 6 percent and a par value (the nominal value of a bond, share of stock, or a coupon as indicated in writing on the document or specified by the charter) of $1,000. The owner of this bond would receive $60 a year in interest, and at the end of 10 years would receive the full $1,000 back.

Under this scenario, the yield of the bond would be the same as the interest rate.

PROCEED WITH CAUTION Many issuers of new bonds will absorb the sales commission themselves, making new bonds more attractive. However, you must always look at the total return, which includes not only fees but also yield and any discount.

Secondary Market

The secondary market for bonds works much like the stock market in that buyers and sellers are matched for a fee. It is in the secondary market that a bond's yield may fluctuate.

Since bonds are issued for a specific interest rate, they react to changes in interest rates. If interest rates rise, the older bond will not be as valuable and must be sold at a discount. When the bond's price falls below par, the yield will drop also. Here's how it works:

XYZ bond is bought at issue for $1,000 with a fixed interest rate of 6 percent for a 10-year term, giving it a yield of 6 percent. After two years, the bondholder wants to sell, but interest rates have risen to 7.5 percent. No one will buy a 6-percent bond at par when they could buy a 7.5-percent bond at par. Translation: Why buy a bond that yields only $60 a year, when you could buy one that yields $75 a year? The answer is discount.

The bondholder will have to reduce, or discount, the face value to make the bond attractive in this market.

JUST A MINUTE The complicated nature of figuring a bond's worth often discourages investors from adding individual bonds to the portfolio.

The formula for calculating a bond's yield follows: annual interest divided by price equals yield.

For the bondholder to match the current yield of 7.5 percent, the par price is discounted on $800. To calculate the yield on the discounted bond, divide the annual interest ($60) by the price ($800) and you get the yield.

For the bondholder to match the current yield of 7.5 percent, the par price is discounted to $800. To calculate the yield on the discounted bond, divide the annual interest ($60) by the price ($800) and you get the yield.

Why would you want to buy an older bond with a lower interest rate? Take a look at this table from the buyers perspective:

	Original Bond Issued @ 6%	2 year-old 6% bond Bought on Secondary Market
Interest Rates	6%	7.5% (2 years later)
Par	$1,000	$1,000
Total Interest	$600	$480
	$1,600	$1,480
Less Original Cost	-$1,000	-$800
Return	$600	$680
Yield	6 percent	7.5 percent

Under the two-year old bond, we see that, if held to maturity, the bondholder would collect $480 in interest ($60 x 8). Added to the $1,000 face value the bondholder will receive at maturity, that gives a total gross return of $1,480. Subtracting the discounted cost of the bond ($800), That leaves the bondholder with a return of $680, or 7.5 percent.

See the advantage? Our bondholder invests $200 less than the original owner and makes more in yield and return.

Here is what the transaction looks like from the seller's perspective:

	Original Bond Issued @ 6%	2 year-old 6% bond Sold on Secondary Market
Interest Rates	6%	7.5% (2 years later)
Par	$1,000	$800
Total Interest	+$600	+$120
	$1,600	$920
Less Original Cost	-$1,000	-$1,000
Return	$600	-$80
Yield	6 percent

Rising interest rates have produced an $80 loss. This points out one of the risk factors in bonds: if you have to sell before maturity, you may suffer a loss if interest rates have climbed.

This is a simple example, although not necessarily representative of real market conditions, which shows the importance of understanding yield. Yield is the primary way you can compare bonds.

JUST A MINUTE Since bonds are tied so closely to interest rates, it is important for bond investors to know what is happening with interest rates and to be especially alert when the Fed board meets.

Professional bond traders use a more sophisticated version of the yield calculation called yield to maturity. Yield to maturity is a complicated calculation that takes into account relationships between price and interest rates. It assumes your coupon or interest payments are reinvested at the same interest rate and compounded. This gives you a way to look at return over time.

There are online tools that help you with this calculation, or your broker can figure it out for you. You can find calculators at About.com's bond site (www.bonds.about.com).

In summary, understanding bond pricing is not difficult, but it is somewhat counter-intuitive. Here are the key points:

• Bonds have fixed interest rates.
• Higher interest rates make lower-interest bonds less attractive, which lowers their price on the secondary market.
• Lower interest rates make higher-interest bonds more attractive, which raises their price on the secondary market.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 202-205*

END

PROCEED WITH CAUTION

Many issuers of new bonds will absorb the sales commission themselves, making new bonds more attractive. However, you must always look at the total return, which includes not only fees but also yield and any discount.

JUST A MINUTE

The complicated nature of figuring a bond's worth often discourages investors from adding individual bonds to the portfolio.

Original

Bond

Issued @

6%

2 year-old

6% bond

Bought on

Secondary

Market

Interest Rates

6%

7.5% (2 years later)

Par

$1,000

$1,000

Total

Interest

$600

$480

$1,600

$1,480

Less

Original

Cost

-$1,000

-$800

Return

$600

$680

Yield

6 percent

7.5 percent

Original

Bond

Issued @

6%

2 year-old

6% bond

Sold on

Secondary

Market

Interest

Rates

6%

7.5% (2 years later)

Par

$1,000

$800

Total

Interest

+$600

+$120

$1,600

$920

Less

Original

Cost

-$1,000

-$1,000

Return

$600

-$80

Yield

6 percent

JUST A MINUTE

Since bonds are tied so closely to interest rates, it is important for bond investors to know what is happening with interest rates and to be especially alert when the Fed board meets.