• Investing in Bond 101

    PFITR
Understanding what shapes the yield curve

Basis point. A basis point is one hundredth of a percentage point. Basis points are used to measure the difference in bond yields. If the yield on a bond falls from 5.10 to 5.03 percent, then the yield has declined by 7 basis points.

Bid and ask price. Bonds are quoted on a bid and ask price. The bid price is the highest price buyers will pay for the bonds. The ask price is the lowest price offered by sellers of the issue. The difference between the bid and the ask price of the bond is known as the spread.

Call provision. Quite a few bonds have a call provision, which means that the issuer of the bonds can call, or redeem, the bonds at a specific price before their scheduled maturity. Issuers exercise the call provision when the market interest rates fall well below the coupon rates of the bonds.

Coupon yield. This is the amount of interest that the issuer of the bond promises to pay the bondholder each year. It may be stated as a percentage of par value. The coupon yield is fixed through the life of the bond issue, unless it is a variable-interest coupon, which changes through the life of the bond.

Current yield. The current yield is determined by this calculation:

Current yield = Coupon interest amount/purchase price of the bond

When a bond is purchased at par, say $1,000, and the coupon yield is 5 percent, interest will be $50 per year and the current yield of 5 percent will be the same as the coupon yield. However, on the secondary market bonds usually trade above or below par. Say that a $1,000 bond carries a 5.75 percent coupon, which is a promise of $57.50 in interest each year. If that bond is purchased at $1,150, the yield is 5 percent, because $57.50 is 5 percent of $1,150.

Bonds trading at a discount to their par values have current yields, which are higher than their coupon rates. Bonds trading at a premium have current yields, which are lower than their coupon rates.

Discount/premium. Usually the only time the bond is at par value is at issuance and maturity. At other times, bonds may trade above or below their par values. Any bond trading below par is referred to as trading at a discount. One trading above par is trading at a premium.

Market rates of interest. Market rates of interest affect bond prices. This is illustrated with the following example. Suppose you bought $100,000 in bonds last year with a coupon rate of 5 percent, when market rates of interest were also 5 percent. But this year the market interest rates have risen to 6 percent.

What price would you get if you tried to sell these bonds now? Obviously, a buyer would not pay $100,000 for the bonds yielding 5 percent when they could buy new bonds at the current coupon rate of 6 percent. Because the buyer would expect to get a yield of at least 6 percent, which means that your bonds would have to sell at a discount (less than $100,000) in order to yield at least 6 percent.

Conversely, if market rates of interest fall below the coupon rate, investors will be willing to pay a premium (above $100,000) for the bonds.

Maturity. The maturity of the bond is the length of time until the bond comes due and the bondholder receives the par value of the bond.

Par value. The par value or face value of the bond is the amount that is returned to the investor when the bond matures. For example, if $100,000 in bonds is bought at issuance for $100,000, the investor bought the bonds at par value. At the maturity date, the investor will get back the $100,000. The par value of a single bond is typically $1,000.

Yield to maturity. This is the discount rate calculated by mathematically equaling the cash flows of the interest payments and principal payments with the price of the bond. This is also known as the internal rate of return of the bond. The yield to maturity is usually calculated on the computer — you’ll like it a lot better that way.

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