Chapter 4-2 Bond Characterisitcs

Bonds are typically distributed in multiples of $1,000.  This is referred to as a bond’s face or par value.  However, a bond’s price is based on market tensions and frequently fluctuates above and below par value.  If you sell a bond prior to its maturity date, you may not get the entire principal total of the bond and will not get any interest payments that are left.  This is because a bond’s price is not established on the par value of the bond.  Rather, the bond’s price is set in the secondary market and therefore changes.  Because of this, the price may be higher or lower than the total of principal and the interest that the issuer would be obligated to compensate you if you retain the bond until its maturity.

There are numerous reasons why the price of a bond can be higher or lower than its par value.  One reason is interest rate adjustments. While another being if the credit rating of a bond has been altered.  Supply and demand also has an effect on bond values, as does a modification in the creditworthiness of a bond’s distributor.  A fifth reason is if the bond has been called, or the anticipated likelihood that it will be called.  And a sixth reason why the price of a bond can be higher or lower than its par value is a change in the general market interest rates.  If a bond trades higher than par, it is said to be trading at a premium.  If a bond trades lower than par, it is said to be trading at a discount.

Yield is a common word that is identified with the return on the money you invest in a bond.  There are many kinds of yield which include coupon yield, current yield, yield-to-maturity, yield-to-call, and yield-to-worst.  A coupon yield is the yearly interest rate set when the bond is distributed.  The coupon yield and the coupon rate are the same.  It is the total income you obtain on a bond and is represented as a percentage of your original investment.  For example, if you purchase a bond for $10,000 and get $475 in annual interest payments, your coupon yield is 4 ¾ percent.  This total is depicted as a percentage of the par value of the bond and will not change throughout the bonds lifetime.  Current yield is the bond’s coupon yield divided by its market price.  If you purchase a new bond at par and retain it until it reaches maturity, the current yield when the bond reaches maturity will be the same as the coupon yield.  However, coupon and current yield do not include reinvested interest.  They also do not aid you if your bond is called sooner than you anticipated, or if you want to calculate the minimum yield you will get from a bond.  Yield-to-Maturity (YTM) is the rate of return you get if you retain the bond to maturity and reinvest all the interest payments at the rate of yield-to-maturity.  It is measured by observing the total value of interest you will get over time, the price you paid for the bond, the face value (the total you will be compensated when the issuer buys back the bond), the time between interest payments, and the time left until the bond reaches maturity.  Yield-to-Call (YTC) is calculated the same way as YTM except it uses a call date and the bond’s call price instead of maturity date and price.  This estimation considers the affect on a bond’s yield if it is called before reaching maturity and should be calculated based on the first date on which the distributor could call the bond.  Yield-to-Worst (YTW) is the lowest of either a bond’s Yield-to-Maturity or Yield-to-Call.  You should do this analysis to identify what is the most stable possible return a bond can provide you with.

The Treasury Yield Curve is a helpful instrument because it offers the essential Treasury bond data points for a likely trading day, with interest rates on the y axis and maturity terms on the x axis.  A general yield curve is one that trends up, signifying that securities with longer durations have a higher yield.  When an upward trending yield curve is relatively flat, it signifies that the difference between the return on a short-term bond and a long-term bond is small.  Investors should consider the risk of retaining a bond for a long time in comparison to the marginally higher interest rate growth they would get from a bond with a shorter term.

Yield curves can be either flat or steep based on economic circumstances and how the Federal Reserve Board is performing.  The yield curve is also affected by what investors anticipate the Federal Reserve Board will do with the money reserve.  A smooth yield curve on an uptrend signifies that there is only a small disparity among short-term and long-term interest rates.  At times economic circumstance and anticipation produces a yield curve with varying features.  For example, a downward trending yield curve signifies that short-term bonds pay more than long-term bonds.  People who examine yield curves typically see this as an indication that interest rates may go down.  The Department of Treasury offers daily Treasury yield curve rates, which can be utilized to set up the yield curve for that day.  Consider the following graphic (from Yahoo! Inc.) that depicts the current treasury yields and the yield curve:


If you have retained a bond for a long period of time, you might want to measure its annual percent return, which is the percent return divided by the number of years you have held the investment.  When you measure your return, you should take into consideration yearly inflation.  Measuring your actual rate of return will provide you with an idea of the purchasing power your profits will have in a particular year.  You can find out the actual return by subtracting the inflation rate from your percent return.  To determine the total return you take the total of the bond when it reaches maturity (or at the time of sale if you sold it before maturity) and sum up all of your coupon profits and compounded interest.  Then you subtract any taxes, any fees or commissions, and your initial investment.  This will provide you with the total profit or loss on your bond investment.  To determine the return as a percent, divide by the original total of your investment and multiply by 100.

Similar to most investment products, bonds produce returns that change from year to year.  Bonds, including U.S. Treasury bills, have advantages and disadvantages just as stocks do.  As you get closer to retiring and you have a need for more conservative investments, arranging your portfolio to contain a larger percentage of bonds is typically advised, partly because stocks and bonds have a tendency to move in inverse directions.  When stock prices go up, bond interest rates usually go down, and when stock prices go down, bond interest rates usually go up.  Coming up with the right investment blend depends on your age, financial goals, and risk tolerance.

There are three important rules to remember about bonds and interest rates.  The first one is that when interest rates go up, the prices of bonds go down.  The second is that when interest rates go down, the prices of bonds go up.  And the third rule to remember is that all bonds have interest rate risk.  Interest rate fluctuations are among the most important determinants influencing bond returns.

One of the key factors for setting a bond’s coupon rate is the federal funds rate.  The federal funds rate is the established interest rate that banks with surplus reserves at a Federal Reserve district bank charge other banks that require overnight loans.  The Federal Reserve sets a goal for the federal funds rate and supports that interest rate by purchasing and selling U.S. Treasury securities.  When the Federal Reserve purchases securities, bank reserves go up, and the federal funds rate is likely to go down.  Conversely, when the Federal Reserve sells securities, bank reserves go down, and the federal funds rate is likely to go up.  Although the Federal Reserve does not determine this rate specifically, it influences it through the purchase and sale of securities.  The federal funds rate, consequently, affects interest rates all over the country including to bond coupon rates.

The Federal Reserve Discount Rate is another rate that considerably influences a bond’s coupon.  It is the rate at which member banks can take a short-term loan on from a Federal Reserve Bank.  The Federal Reserve Board has complete control over this rate.  If the Federal Reserve Board increases the discount rate by a half of a percent then the following U.S. Treasury auction for new Treasury bonds will likely value the securities to show the higher interest rate.  If interest rates drop, the treasury bonds that you may have purchased a few months ago are not as appealing.  If you want to sell them, you have to reduce their price to a value that is on par with the coupon of every new bond that has just been distributed at the higher rate.  This means that you would have to sell your bonds at a discount.  If, for example, you purchase a bond with a 5 ½ percent coupon a few years ago and you need to sell it four years later and the interest rates are now at 4 ¼ percent, the bond now becomes more appealing as opposed to others.  You would be able to sell the bond at a premium.

When referring to bonds and interest rates, you often hear the term basis points, or bps.  A basis point is one one-hundredth of a percentage point, or .01.  100 basis points is equivalent to one percent.  Bond traders and brokers customarily utilize basis points to specify dissimilarities in bond yields.  The Federal Reserve Board is inclined to utilize bps when alluding to fluctuations in the federal funds rate.

Bond investors are aware of pivotal or leading economic indicators, primarily watching for any possible affect these economic indicators may have on inflation and interest rates.  Different branches of the federal government keep account of a number of these leading indicators, but not all of them.  Some of the online resources which can be of help to you are the U.S. Census Bureau’s Economic Briefing Room and Economic Calendar, the U.S. Department of Labor, Bureau of Labor Statistics, and the Conference Board’s Economic Indicators.  The Federal Reserve Board’s calendar of Federal Open Market Committee, also known as FOMC, establishes specific interest rates that are utilized by some in the bond market to decide all other interest rates.

Interest rate risk is the risk that fluctuations in interest rates in the U.S. or the world may affect the market value of a bond you hold.  Interest rate risk, also known as market risk, increases the longer you keep a bond.  With respect to rising interest rates, there are two things that can occur:  If you purchased a bond and you need to sell it prior to its maturity date and the interest rates have gone up in the time that you held the bond, you have to contend with newly issued bonds with coupon rates higher than that of the bond you are holding.  These bonds with higher coupon rates reduce the demand for older bonds that pay lower interest.  This lowered demand decreases the price of the prior bonds in the secondary market, which means that you will get a reduced price for your bond if you have to sell it.  Rising interest rates make new bonds more appealing due to the fact that they have a higher coupon rate.  This leads to what is referred to as opportunity risk, or the risk that a more favorable opportunity will show up that you might not be able to act on.  The more time a bond has until it reaches maturity, the more likely that a more appealing investment opportunity will present itself. The same risks that individual bondholders face, bond fund managers also confront.  When interest rates go up, particularly when they rise abruptly, the value of the fund’s current bonds go down which can slow down the fund’s overall performance.

Bonds with a call provision may be redeemed or called by the issuer, necessitating you to redeem the bonds at their face value prior to their maturity dates.  Similar to how a homeowner looks to refinance a mortgage when rates go down, a bond issuer frequently calls a bond when interest rates go down.  This allows the issuer to sell new bonds at a lower interest rate and therefore save money.  The bond’s capital is paid back sooner, but the investor may find it hard to find a comparable bond with an equally appealing yield.  This scenario demonstrates call risk.  You may not receive the bond’s initial coupon rate for the whole term of a callable bond.  It may also be hard or inconceivable to come across a similar investment that returns as much as the starting rate.  This scenario demonstrates reinvestment risk.  Moreover, when the call date arrives, the flow of a callable bond’s interest payments is doubtful and any increase in the market value of the bond may not increase beyond the call price.

One of the characteristics frequently included in bonds distributed by industrial and utility companies is a sinking fund provision.  A sinking fund provision necessitates a bond distributor to call a determined number of bonds regularly.  This can be carried out through buying in the secondary market or obligatory buying directly from bondholders at a set price.  Investors that hold bonds that are subject to sinking funds should comprehend that they risk having their bonds called before reaching maturity, and are therefore subject to reinvestment risk.