Investment Bonds Primer

Erik J Abel
ejabel@gmail.com

Who Issues Bonds and Why? ..............................................................................................4

Bond Structure .....................................................................................................................5
Payment Structure................................................................................................................6
Risk ......................................................................................................................................7
Credit Risk ...........................................................................................................................8
Issuer Type.....................................................................................................................8
Length to Maturity .......................................................................................................10
Credit Rating (Risk Premium) .....................................................................................11
Call Provision Risk ......................................................................................................11
Interest Rate Risk...............................................................................................................12
Issuing Bonds: The Primary Market ..................................................................................13
Coupon Rate.................................................................................................................13
Credit Enhancements ...................................................................................................13
Negotiated or Competitive Offering ............................................................................14
Pricing Bonds: The Secondary Market ..............................................................................14
Bond Yields .......................................................................................................................16
Nominal/Current Yield ................................................................................................16
Yield to Maturity..........................................................................................................17
True Yield ....................................................................................................................18

© 2009 Erik J Abel [ejabel@gmail.com]

Investment Bonds Primer

Purpose
This tutorial provides a comprehensive overview of the purpose of investment bonds. It
describes where they come from, and how they function as financial instruments, and in
the bond market.

The process of structuring bond issues over the years has developed many conventions
and features. There are also many less-common, creative and novel structures and
features. This tutorial does not address every possible bond construct. It describes many
of the fundamental and most common structures and features to get you started in
understanding investment bonds.

This tutorial does not:

• Provide investment advice
• Guide you in developing a strategy for how to invest in bonds
• Guide you in choosing in which type of bonds to invest

Acknowledgements
I wish to express my deep felt appreciation to the people (O.G. and J. P.) who shared
their knowledge and time in reviewing this document and providing thoughtful comments
and corrections. I’m grateful for the improvements that their help initiated. I also wish to
thank D.S. for her loving encouragement and support and for motivating me to edit.

© 2009 Erik J Abel [ejabel@gmail.com]

Investment Bonds Primer
Erik J Abel

To function in an economy - to run a government, to manage a business, to conduct our

lives – on occasion, we need to borrow money. As individuals, we can borrow money –
get a loan – from financial institutions, friends or family. Governments and businesses
have the credit-worthiness to borrow money from the financial markets.

Issuing bonds is the method by which governments and businesses borrow money from
the financial markets. A bond is similar to a personal loan. Think about what you would
want to know if you were asked to make someone a loan and you will understand the
basic terms of a bond:

• How much do they want to borrow?

• For how long is the money needed and when will you be paid back in full?
• What are you going to get in return for lending the money? When are they going
to give this to you? At regular intervals throughout the term of the loan? At the
end of the loan period, when they pay back your money in full?
• How much do you trust that you will get paid back?

However, a major difference between your buying a bond and making a personal loan is
that you may seek to purchase a bond because of its value to you as an investment. As
such, you will shop for a bond that meets your financial objectives in terms of how much
you expect to earn from it. How much you can expect to earn on a bond is determined by
many factors. Some of these factors include the length to maturity of the bond and the
credit rating of the bond and the bond issuer.

But bonds are not only loans. Because a bond holder may want to be paid back in full
before the bond matures (before the issuer is obligated to do so), bond holders can and do
sell their bonds to others. Thus bonds are also financial instruments that can be traded in
the financial markets, known in the industry as the secondary market.

The value of a bond to an investor is as a fixed income investment – an investment that

pays the investor regularly scheduled amounts over time for the use of their money. This
concept of a fixed-income, a future cash-flow, informs how bonds are priced in the
financial markets. In the financial markets the finance theory concept of a discounted
cash-flow is used to establish current prices for bonds.

Now, we conclude our introduction to bonds with a more formal description of what a
bond is:

© 2009 Erik J Abel [ejabel@gmail.com] 3

A bond is a negotiable financial instrument known as a debt security. A bond issuer asks
a bond holder to give them an amount of money for a period of time. In exchange, the
issuer promises:
• To pay the full amount of the loan back to the holder at a predetermined time in
the future
• To reward the holder by paying a percentage of interest on the amount invested
• To pay this at regular intervals throughout the life of the bond, or at maturity in a
lump sum larger than the amount the bond holder invested.
It is a formal contract to repay borrowed money with interest at fixed intervals.

Who Issues Bonds and Why?

The sale of bonds in the financial markets is regulated. For a bond to be bought and sold
on the financial markets - to be a marketable financial instrument - it must be registered
with and follow the rules of securities regulators.

Regulators limit the ability to issue bonds as marketable debt securities to those parties
who can demonstrate the ability to repay the debt based on current earnings. Few
institutions have the cash-flow or personnel resources to demonstrate this. Therefore,
issuing bonds as a registered offering on the financial markets is limited in the United
States to primarily three types of parties:

• The Federal government and Federal agencies

• State and municipal governments
• Corporations including:
o Public utilities
o Transportation companies
o Industrial corporations
o Financial services companies
o Conglomerates

The U.S. federal government issues bonds to cover some portion of its regular
expenditures. It meets regulators criteria of demonstrating the ability to repay debt,
because the federal government always has the option of raising taxes to redeem the bond
at maturity.

State governments obtain their source of security for debt typically from income or sales
taxes; Municipal governments usually from property taxes; agencies - such as water or
turnpike authorities - through fees; and local governments from property taxes.

Corporations issue bonds to fund operations or growth. The types of corporations that can
issue bonds are generally businesses with a good cash flow such as utilities with an
exclusive contract to provide a service. Corporations can raise capital through stock
offerings and bank loans. However, they may choose to raise it through bond offerings
because:
• Companies view borrowing from a bank as more expensive than issuing bonds

4 © 2009 Erik J Abel [ejabel@gmail.com]

 • Cost of equity is consider more expensive than cost of debt as:
- Stock dividends are taxed as income
- Interest on debt is tax-deductible as an expense, and so reduces a corporation’s
income tax burden
We’ll get into the process by which institutions issue bonds in a later section. First, let’s
get familiar with the structure of a bond.

Bond Structure
As an investment, bonds provide you with a cash-flow over a set period of time including
the return to you of the face value of the bond. Bond issuers provide you with this cash-
flow in exchange for their use of your money now. Bonds - like loans - are subject to
credit risk, that is, the risk that the issuer will default or stop paying you what the terms of
the bond promised. The structure of a bond includes the following components:

Face/Par Value Bonds are commonly issued in $1000 (to $5000) increments.
This is the principal amount that the issuer repays when bond
reaches maturity; the par or face value of the bond.
Price Amount that a bond buyer pays for a bond which may be
above or below face value.
Above par = premium
Below par = discount
Maturity Time in the future when issuer repays principal value of bond
to bond holder. Interval ranges from 1 month to 40 years.
Interest/Coupon/Yield Interest
Interest rate fixed at time of bond issuance. A percentage of
the bond amount paid to bond holder at regularly scheduled
intervals over the life of the bond. Called nominal interest.
Various factors go into determining the interest paid on the
bond including: market interest rates and the credit risk-level
of the bond and issuer.

Coupon
The interest paid on a bond is also called the coupon. This
term comes from the no longer used practice of issuing
physical paper certificates with coupons attached representing
each interest payment. The bond holders would detach and
redeem the coupons to receive each interest payment.

Yield.
Interest is often referred to as yield; however yield has a
number of meanings in relation to bonds in addition to
nominal interest rate.

In evaluating bonds, yield tells you the annual rate of return.

© 2009 Erik J Abel [ejabel@gmail.com] 5

Bonds are categorized into types in part based on the following components:

Payment structure The type of payment structure the bond offers. The payment
structure specifies where your cash-flow comes from: coupon or
zero-coupon.
Issuer Type Bonds are organized and tracked by type of issuer: treasuries,
municipal, corporate.
Level of risk Factors associated with risk to the bond holder include:
• Issuer type
• Length to maturity
• Risk-level rating by a third party agency (ranges from
investment grade (safest) to junk (riskiest)).
• Interest rate:
o Safer bonds pay lower rates
o Riskier bonds pay higher rates.
Interest rate Lower interest rate bearing bonds are considered safer than
higher interest rate bonds. Bonds pay a higher interest rate as a
premium for greater risk due to greater length to maturity or
poorer creditworthiness of issuer.
Call provisions Some bonds come with the rights of issuers to call the bonds
before maturity.

The following sections go into these bond components in more detail.

Payment Structure
Bonds are categorized by the two primary payment structures:

Coupon Bonds that pay interest at fixed intervals and

return the face value of the bond at maturity.
Zero-Coupon Bonds sold for below face value and that return the face value of the
bond at maturity. These bonds do not pay a coupon, thus the name
zero-coupon. U.S. savings bonds, where you pay $25 and receive $50
at time of maturity, are an example of zero-coupon bonds.

Coupon Bond Example

You buy a corporate bond with the following characteristics:

Face value $1000

Price $1000
Maturity 5 years
Interest/Yield 5 %, paid annually
What you receive $1250
through bond • $1000 principal
maturity • 5% interest per year = $50
by 5 years (5 x 50) = $250

6 © 2009 Erik J Abel [ejabel@gmail.com]

The coupon bond pays annual interest each year to maturity, plus returns the face value of
the bond to you at maturity.

Zero Coupon Bond Example

You buy a U.S. Treasury Bill with the following characteristics:

Face value $1000

Price $ 980.79
Maturity 52 weeks
Interest/Yield None
What you receive $1000
through bond
maturity

You purchase a zero-coupon bond at a discount from face value and are returned the face
value of the bond at maturity. Although a zero-coupon bond does not pay interest while
the bond is outstanding, the discount from face value is an implied interest rate (discount
rate) - the rate by which the bond was discounted. You earn on your investment in a zero-
coupon bond the difference between what you pay for the bond and the face value of the
bond.

Various types of bonds offer various tax advantages or disadvantages. You want to
consider the tax treatment of various bond types before choosing in which type to invest.
For example, some bonds are taxable at the federal level but not at the state or local
levels, or vice versa. You must pay taxes on the interest you earn on a taxable bond at the
time that you receive the interest. Although zero-coupon bonds do not pay interest, if a
zero-coupon bond is taxable, it is taxed during the life of the bond as though you were
receiving a percentage of your earnings as interest through out the life of the bond. So
with zero-coupon bonds, you must pay taxes on money you do not yet have in your
possession. On the other hand, once you do receive your earnings, you have paid off the
taxes.

Risk
As loans and marketable financial instruments, bonds are subject to the following types
of risk:

• Credit risk (risk of default)

• Interest rate risk

In addition, some bonds are also subject to issuer-rights risk in the form of call
provisions.

© 2009 Erik J Abel [ejabel@gmail.com] 7

Credit Risk
As we stated earlier, regulators limit the ability to issue bonds as marketable debt
securities to those parties who can demonstrate the ability to repay the debt based on
current earnings. Although an issuer might have good enough credit to qualify to issue
bonds, the range of the creditworthiness of these institutions varies from being very safe
from default to being more at-risk of default. In addition, an institution’s financial
situation can change; an institution that was financially healthy when a bond was issued
may not be so by the time a bond matures. The risk that an issuer may be unable to
continue paying interest on a bond, or to buy back a bond at maturity (to pay back the
loan), that it will default in some way is called credit risk and is always present to varying
degrees.

A bond’s credit risk is categorized by:

• Issuer type
• Length to maturity
• Issuer’s/bond’s credit rating

The market charges for bearing credit-risk. Therefore, in general, the greater the credit-
risk of a bond, the higher the rate of interest that the bond pays. The following sections
explain the issues that go into factoring a bond’s credit risk.

Issuer Type
As the various types of issuers have different methods and sources of securing the debt
that they issue, they pose varying levels of credit risk.

The rank of credit-risk by issuer type is as follows, from least to most risk:

Less Risk

• Federal government bonds

• Municipal/Corporate bonds

More Risk

U.S. Federal Government

Bonds issued by the U.S. Federal government are considered to offer the least credit risk
of any bonds in the market because:
• The Federal government always has the option of raising taxes to redeem a bond
at maturity
• The Federal government and agencies have never defaulted on a bond

8 © 2009 Erik J Abel [ejabel@gmail.com]

Because of the perception of their safety, federal bonds are central to the financial
markets as benchmarks for valuing other debt securities.

The ability to raise taxes to redeem a bond at maturity alone is not sufficient to prevent a
government from defaulting on bonds; other country’s national governments have
defaulted on bond issuances. One factor in some foreign government’s bond defaults is
an exchange rate risk when they issue bonds in foreign denominations. For example,
Argentina had issued external debt denominated in U.S. dollars rather than Argentine
pesos and eventually defaulted on these bonds in 2002 due to exchange rate issues.

Municipal
Bonds issued by state and local governments and agencies do occasionally default.
Economic or political problems can cause a government entity’s credit rating to degrade.
Municipal bonds are categorized by type according to the repayment source, which offer
various levels of default risk. Municipal bonds are generally of three types:

Municipal Bond Type Risk

General obligation These bonds offer the greatest level of security because the
issuer promises to repay based on the full faith, credit and
taxing powers of the government that issued the bonds.
Revenue These bonds must be repaid from a specific stream of
income (such as utility fees). If money is not available from
that income stream, bonds may not be repaid.
Assessment These bonds are repaid based on property tax assessments.
Because tax assessments can vary, repayment is less secure.

Corporate
As a security, the ownership of a corporate bond differs from ownership in a stock in
that:
• Bond holders are lenders to the corporation who issued the bond. As lenders they
are due to be paid back even if the company issuing the bond goes bankrupt.
• Stock holders are owners of the corporation whose stock they bought, and lose
their investment if the company goes bankrupt

A bond-holder’s risk is in the overall financial stability of the issuer only, while a stock
holder’s risk lies in the profitability and solvency of the issuer.

However, not all bond holders have an equal stake on the company. Debt is categorized
as follows:

Secured Backed by collateral of some kind of asset that can be seized to satisfy
the debt.
Unsecured Not backed by collateral.

In the event of the issuers’ bankruptcy, holders of secured debt are paid first. Bonds
issued as secured debt are less risky than bonds issued as unsecured debt.

© 2009 Erik J Abel [ejabel@gmail.com] 9

Length to Maturity
The longer a bond remains outstanding the greater the chance that the issuer’s financial
condition can change for the worse, and that the issuer can default on the bond.

The rank of credit-risk by maturity is as follows, from least to greatest risk:

Less Risk Classification Maturity

Short-term < 2 yrs.

Intermediate-term 2 to 12 yrs.
(Intmd)

Long-term >12 yrs.

More Risk

The following diagram shows how bonds are rated for risk on a continuum by:
• Issuer type
- Federal securities (Fed/secs)
- Municipalities (munis)
- Corporations (corps)
• Maturity lengths
- Short-term
- Intermediate-term (Intmd)
- Long-term

Risk level Least Some More Most

Maturities by - Short- Fed/Secs - Short-munis - Intmd-corps - Long-munis

- Short-corps - Intmd-munis - Long-corps
issuer type - Intmd-Fed/Secs - Long-Fed/Secs - Un-secured corps
- Secured corps

Interest rates Lower Higher

10 © 2009 Erik J Abel [ejabel@gmail.com]

Credit Rating (Risk Premium)
Credit rating agencies such as Moody's, Standard and Poor's and Fitch Ratings analyze
bond issues to determine the level of risk that the bond could default. They then assign a
rating to the bond that can range from various levels of investment grade to various levels
of being speculative. In addition to being a gauge by which investors can determine the
relative safety or risk of a bond, the credit rating also factors in to determining any
additional amount of interest a bond must pay. This additional amount of interest is a
premium for an investor’s willingness to take on additional risk. As shown in the
following diagram:

• Higher grade bonds offer:

- Lower credit risk (risk of default)
- Lower interest rate risk premiums

• Lower grade bonds offer:

- Greater credit risk
- Higher interest rate premiums

Credit Rating Categories

Ba1-Ba3 Caa3-Ca
A1-A3 (Non Caa1 (Little
Aaa (Upper Investment (Substantial Prospect for
(Prime) Medium) Grade) Risk) Recovery)

Investment In
Grade Default
(High) (Lower (Highly (Extremely
Aa1-Aa3 Medium) Speculative) Speculative)
Baa1-Baa3 B1-B3 Caa2

Credit Risk Lower Higher

Interest Rate Lower Higher

(Risk Premium)

A bond’s credit rating can change over time as the financial condition of the issuer
changes. Bonds with lower credit ratings are more sensitive to new information about the
issuer than are those with higher ratings.

Call Provision Risk

This is the risk that the issuer can choose to payback your bond before its maturity. A
called bond thus deprives you of anticipated income through the years until the defined
maturity date. A call provision is established for a bond at the time of its issuance, so you
can know before you purchase a bond whether it is callable. Because of the risk of losing
anticipated future income, callable bonds offer a higher coupon/interest rate than non-
callable bonds.

© 2009 Erik J Abel [ejabel@gmail.com] 11

An issuer typically exercises the option to call a bond when interest rates go down. This
way, the issuer can save money on servicing debt by retiring bonds issued at a higher
interest rate and issuing new ones at a lower rate. Thus, if you want to replace a bond that
was called, you will likely get a new bond with a lower coupon rate as coupon rates in the
bond market at that time are lower.

Interest Rate Risk

The prices of bonds fluctuate with changes in the interest rates charged for borrowing.
This is known as interest rate risk. There is an inverse relationship between bond prices
and interest rates. As interest rates change, the prices of bonds change in the opposite
direction as follows:

Rising interest rates Rising bond prices

Bond Prices Interest Rates

Interest Rates Bond Prices

Declining bond prices Declining interest rates

We’ll get into a description of how and why this happens in the section on pricing bonds.

As interest rates change the price of a bond may be at a:

Description Example
Discount Price is below face value of the bond. Face value: $1000
Price: $ 900
Note: Zero-coupon bonds are sold at a
discount regardless of interest rate
changes.
Premium Price is above face value of the bond. Face value: $1000
Price: $1100

12 © 2009 Erik J Abel [ejabel@gmail.com]

Issuing Bonds: The Primary Market
When an institution seeks to borrow money by issuing bonds, it must first structure the
bond offering. Structuring a bond offering includes planning how much debt to take on,
how to finance that debt, and preparing legal documentation. A bond issuer uses an
underwriter – a registered securities dealer or investment bank – to aid in structuring the
issue. The underwriter helps the issuer establish the financing terms - particularly what
interest rate to pay as a coupon on the bonds; to get a rating for the bonds from a credit
rating agency; and can be the primary purchaser of the bonds.

Coupon Rate
The underwriter sets the interest rate that the bonds pays to investors based on a
combination of the following at the time the bond is issued:

Factor Description
Federal funds rate The prevailing interest rate that banks with excess reserves at a
Federal Reserve district bank charge other banks that need
overnight loans.
Federal Treasury Bond issuers use the interest rates of federal securities of a
securities similar maturity to their bond issue as a benchmark for setting
the interest rate on their bonds.

And a risk premium rate based on a credit rating of the institution issuing the bonds. The
credit rating is assigned by a credit rating agency such as Moody’s, Standard & Poor’s, or
Fitch Ratings.

Credit Enhancements
An issuer can lower the risk premium set on a bond issuance through a credit
enhancement. Credit enhancements include obtaining a letter of credit from a commercial
bank or purchasing bond insurance. A credit enhancement allows the issuer to borrow the
credit rating of the letter-of-credit or insurance provider and thus for the bonds to be rated
based on the provider’s credit-rating rather than the issuing institution’s. Although
obtaining a credit enhancement increases the cost of issuing bonds, it often saves the
issuer money. This is so, because the credit enhancement reduces the credit risk of the
bonds and thus the amount of interest the issuer has to pay on the debt. The reduced
interest rate makes up for the cost of the credit enhancement. Issuers find it easier and
less expensive to obtain bond insurance than letters of credit.

In addition to lowering their risk premium through credit enhancements, bond issuers
have many ways of strategically structuring bond issuances to minimize the overall cost
of issuing debt. For example, they can reduce the cost of a debt issuance by issuing a type
of bond known as a convertible bond. Because a convertible bond is viewed as offering
greater safety than other types of bonds, use of these reduces the amount of interest the
issuer is required to pay on the debt.

© 2009 Erik J Abel [ejabel@gmail.com] 13

Negotiated or Competitive Offering
When the issuer chooses a firm to structure the bond issuance, it can select a firm to both
structure the bond issuance and to be the underwriter (primary buyer of the bonds), or it
can use different firms for each. In fact, for many sizable issues, the investment bank is
actually a syndicate of a number of firms acting as one, with one firm leading. This is
true particularly for the underwriting, as any single investment bank may not have the
capital or desire to take the risk of funding an entire bond issuance.

If an issuer selects an investment bank or syndicate to both structure and underwrite a

bond issuance it is called a negotiated sale, as the issuer and underwriter negotiate the
terms of the bond financing together. Since the underwriter in a negotiated offering is
assured the right and obligation to purchase the bonds, the underwriter may aid the issuer
in determining a market for the bonds by testing the market through its own sales
channels. In a negotiated sale, the underwriter may also begin marketing the bonds before
they are formally issued.

If the issuer seeks a different investment bank or syndicates from the one that structured
the bond issuance to underwrite it, it is called a competitive or bid offering. In this type of
offering, the issuer seeks bids on the financing of the bonds from multiple underwriters.
The underwriter who offers the lowest interest rate to finance the bonds wins the bid and
the right/obligation to purchase and re-sell the bonds through its sales channel. The
Federal Treasury securities auctions are an example of a competitive bid offering.

The bond financing also includes profit for the underwriter. The underwriter typically
buys the bonds for less (up to two percent less) than the price at which they sell them.

Pricing Bonds: The Secondary Market

Once a bond underwriter begins to sell bonds through its sales channels to its customers,
the bonds are selling on the secondary market. Both newly issued bonds and previously
issued bonds that have gone unsold or that are being re-sold are for sale on the secondary
market. Most bonds are sold on the secondary market in over-the-counter trading
between broker-dealers rather than on an exchange such as the stock market exchanges.

The sale of bonds on the secondary bond market is predicated on the idea that investors
want to own the bonds with the best yields within their risk level classification. So that all
bonds on the market can potentially be sold, the market prices bonds so that the yields on
bonds with varying coupon rates are somewhat equivalent.

To understand how bonds are priced, you must understand the idea that when you buy a
bond, you are purchasing a future cash flow (your fixed income). For example, if you buy
a bond with the following characteristics and hold it until maturity:

Annual Coupon
Par Value Coupon Rate Payment Maturity Cash Flow Yield
$1000 5% $50 5 years $50 x 5 years $250

14 © 2009 Erik J Abel [ejabel@gmail.com]

Your cash flow from this bond is $50 a year for five years and you yield $250 in total by
maturity. But it is a future cash flow; you do not have possession of all the $250 at
present.

Bonds on the secondary market are priced using a discounted cash flow model. This
model is based on the finance theory concept of the time value of money. According to
the time value of money concept, money you have in your possession now (present) is
worth more than money you will have in the future. This is so because you can increase
the value of money you have now by obtaining interest on it. Thus, the market prices
bonds so that bond prices reflect the present value of their future cash flow. In so doing,
the market prices bonds so that the yields of various bond issues are not widely skewed
from other issues.

To calculate the present value of future money, you discount its value. Some percentage
is used to discount future values. In this case, an interest rate and the interest rate used to
make this calculation is called the discount rate.

The discount rate used for pricing bonds comes from a composite of the risk-free interest
rate and benchmarks of bonds of similar structure (like treasuries). Thus, in pricing the
future cash flows of bonds to their present values:

Interest Rate Bond Price

Movement Movement Explanation
Up Down The present value of each future cash flow is worth
less, since a bond offered today would have a higher
cash flow/coupon rate.
Down Up The present value of each cash flow is worth more,
since a bond offered today would have a lower cash
flow/coupon rate.

In addition, the length to maturity of a bond is a factor in a bond’s price sensitivity to

interest rate changes. The longer period to maturity of a bond the greater the price
sensitivity to changes in interest rates than that of bonds of shorter maturities.

If you purchase a bond when it is first issued and hold it until maturity, the price volatility
of bonds does not really affect you. What affects you is the rate of return on your bond
compared with the rate of return on newly issued bonds. As new bond issues may have a
lower or higher coupon rate than a bond that you hold, by holding your bond to maturity
your rate of return may be lower or higher than the coupon rates of newly issued bonds.
The price volatility of bonds affects you when you buy bonds after they are issued, or sell
them before they mature. Calculating your yield on a bond that you purchase after
issuance or sell before maturity is more complex.

© 2009 Erik J Abel [ejabel@gmail.com] 15

Bond Yields
A bond’s yield tells you how much money you will make from investing in the bond. If
you buy a bond at initial offering and keep it until maturity, determining the yield is
relatively straight-forward; its yield is the coupon rate or the sum of all of the coupon
payments. If you buy a bond on the secondary market, when the price of the bond is
above or below par, calculating its yield is more complex. In this scenario, you can
calculate the yield as:

Current yield Provides a comparison of the coupon rate to the current market
price. That is, what percentage the coupon payment is of the
price of the bond. This calculation shows what the market is
willing to accept as an effective interest rate on a bond.
Yield-to-maturity An estimated cumulative return on a bond including:
(YTM) • All coupon payments
• Return of face value of bond.
• Compound interest on all coupon payments to bond’s
maturity.

Of these two methods of calculating yield, yield to maturity is the more accurate
calculation of what you will make on an investment in a bond.

Nominal/Current Yield
The following table describes nominal and current yield and how you can calculate each
for a bond with the following characteristics:

Par Value Coupon Rate Annual Coupon Payment Maturity

$1000 5% $50 5 years

Calculated For Calculation Example

Yield A bond priced at par. Coupon amount
(Nominal) face value x coupon rate $1000 x 5% = $50
Yield is equal to
coupon rate, coupon Coupon rate
payment amount, or coupon amount / face value $50 / $1000 = 5%
sum of coupon
payments.
Current A bond priced below coupon rate / price 5% (.05) / $900 = 5.5%
Yield or above par. 5% (.05) / $1100 = 4.5%
or
The effective
percentage rate of coupon amount* / price $50 / $900 = 5.5%
return of the coupon $50 / $1100 = 4.5%
payments given a (*calculated from face
bond priced above or value x coupon rate)
below par.

16 © 2009 Erik J Abel [ejabel@gmail.com]

Another way of looking at the effects of changing bond prices:

At par (face value) Current yield is equal to coupon rate. 5%

Below par (discount) Current yield is higher than coupon rate. 5.5% [5% / $900]

Above par (premium) Current yield is lower than coupon rate. 4.5% [5% / $1100]

Thus, we can see that as bond prices respond to interest rates, naturally, so too do the
current yields on existing bonds (and the nominal yields/coupon rates of new bond
issues).

Bond current yields respond

with interest rates.

Rising interest rates Rising current yields Rising bond prices

Bond Prices Interest Rates Bond Current Yields

Interest Rates Bond Current Yields Bond Prices

Declining bond prices Declining interest rates Declining current yields

Yield-to-Maturity
Again, of the methods of calculating yield for changing bond prices – current yield and
yield to maturity - yield to maturity is the more accurate calculation of what you will
make on an investment in a bond. This is the recommended yield to calculate when
comparing different bonds that you are considering purchasing.

Yield to maturity calculates an estimate of the cumulative return on a bond including:

• The sum of the coupon payments
• Difference you receive in return of face value of the bond, if you purchased it
below or above par
• Compound interest (at same interest rate as coupon rate) on coupon payments

A YTM calculation is fairly complicated but basically calculates the present values of all
payouts so that when you add up these present values, the sum will equal the bond price.
However to simplify doing this calculation for yourself, you can use an established YTM
calculator.

© 2009 Erik J Abel [ejabel@gmail.com] 17

The following example shows the YTM differences for a bond with the following
characteristics, as calculated using a YTM calculator, for a bond priced at par, below par,
and above par.

Par Value Coupon Rate Maturity

$1000 5% 5 years

Par Value Bond Price Yield to Maturity

$1000 $1000 5%
$1000 $950 6.19%
$1000 $1050 3.88%

True Yield
Although we’ve shown calculations for current yield and yield to maturity, the true
measure of what you make on a bond includes other fees and costs. Without going into
too much detail here, other fees and costs associated with purchasing a bond and that
must be factored into a calculation of what you ultimately earn on a bond include:
• Commission to bond dealer/broker for purchasing the bond
• Accrued interest on next coupon payment - if you purchase a bond between
coupon payments, you must pay the amount of interest accumulated towards the
next coupon payment at the time that you purchase the bond.
• Taxes

18 © 2009 Erik J Abel [ejabel@gmail.com]