Understanding Bonds
Pricing and the yield curve.
Three essential factors in the pricing of bonds.
- Interest rates:
When you own debt, the entity whose bond you purchased will give you “coupon” payments over time, which is determined by an interest rate. The amount of interest you receive from a bond is an external factor from the entity you purchased it from — even if you buy U.S. treasury bonds, the federal reserve controls monetary policy via supply of cash and interest rates. So, if you own a newly issued bond with a par value of $1000 with coupon payments of $50, the bond will have an interest rate of 5%.
2. The Yield
The yield of the bond is determined by comparing the current market value of the bond to its coupon payment (which is based on interest). For example, say that the bond is trading $200 dollars below par ($1000) at $800 with an interest rate at 5% . The yield changes based on the current value of the bond. If the bond is trading at $800, with an interest rate of 5%, the yield will then be 6.25% ($50 CP/ $800 Bond). A bond whose yield is higher than its interest rate is said to be trading at a discount. Inversely, a bond whose yield is lower than its interest rate is said to be trading at a premium. Example, bond value is $1200 with a 5% interest rate and $1000 par. The yield is then 4.16% ($50 CP/ $1,200 Bond.)
3. The Yield To Maturity
The yield to maturity can easily be understood by likening it to an internal rate of return (IRR). The yield to maturity takes in future cash flows of the bond at its current price by discounting the future cash flows back into present dollars (A conservative discount rate would be the one year treasury bond). As the interest rate increases, the yield to maturity also increases. As the interest rate decreases, the yield to maturity also decreases. This is because as interest rates increase, the value of the bond you hold falls while the interest payment in respect to its current lower price increases. Since YTM is a function of present price and future cash flows from coupon payments the YTM will rise with higher interest rates.
The Yield Curve
Normal Yield Curve
To the left is a normal yield curve. This curve reflects increased yield (return) based on a longer maturity (time is a major risk component as seen by the role of discounting future cashflows). During the normal yield curve, shorter maturity bonds have a lower yield than longer maturity bonds due to the possibility of future higher interest rates.
The inverted yield curve
To the left is the infamous inverted yield curve. The graph represents that bonds with a shorter duration have a higher yield than bonds with a longer maturity. Counterintuitive to risk / reward. This is a leading sign of a recession due to a short term debt cycle. When the curve inverts investors buy shorter term bonds anticipating a decrease in interest rates. When interest rate falls, so does the yield. Therefore the investor tries to lock in his yield before the rates continue to fall.
Ratings of bonds.
Bonds are rated as AAA, AA, A, BBB, BB, B+,B, V- CCC, CC, C, D.
U.S. government bonds are considered AAA as they are backed with the full confidence of the United States government. However, corporate bonds are priced on coverage ratios, which means the quality of the bond is based on the companies ability to pay back principal and interest of the debt that they took on. (Note BB is the lowest investment grade bond, B+ and below is considered junk). There are many different ratios which are used to measure a companies ability to repay its borrowings, including DSCR (debt service coverage ratio), Interest coverage ratio and times burdened covered (EBIT/ interest+principal).
