With most bonds, the
interest rate never changes, even though other interest rates do.
If the bond is paying more interest than is available elsewhere, you,
as an investor, may be willing to pay more than par value to own it.
If the bond is paying less than market interest, the reverse is likely
to be true.
Interest rates and bond prices fluctuate like two sides of a seesaw.
As the table below illustrates, when interest rates drop, the value
of existing bonds paying a higher rate usually goes up. When rates
climb, the value of existing bonds paying a lower rate usually falls.
Several factors — including yield and return —
affect whether or not any bond turns out to be a good investment.
|
| |
|
| Par
value: |
$1,000 |
| Term: |
10
Years |
| Interest
rate: |
6% |
|
| Market
value |
$800 |
| Interest
(x2) |
+
120 |
| |
|
| Total
value |
920 |
| Less
original cost |
–
1,000 |
| |
|
| |
|
|
| Market
value |
$1,200 |
| Interest
(x3) |
+
180 |
| |
|
| Total
value |
1,380 |
| Less
original cost |
–
1,000 |
| |
|
| |
|
|
| |
|
|
|
|
|
|
|
|
| Par
value |
$1,000 |
| Interest
(x10) |
+
600 |
| |
|
| Total
value |
1,600 |
| Less
original cost |
–
1,000 |
| |
|
| |
|
|
| Par
value |
$1,000 |
| Interest
(x8) |
+
480 |
| |
|
| Total
value |
1,480 |
| Less
original cost |
–
800 |
| |
|
| |
|
|
| Par
value |
$1,000 |
| Interest
(x7) |
+
420 |
| |
|
| Total
value |
1,420 |
| Less
original cost |
–
1,200 |
| |
|
| |
|
|
|
|
|
|
|
| |
PAR
FOR THE COURSE
If you buy at par, and
hold the bond to maturity, inflation, or the shrinking value
of the dollar, is your worst enemy. The further in the future the
bond matures, the greater the risk that at some point inflation will
rise dramatically and reduce the value of the dollars that you are
repaid.
If the bond pays more than the rate of inflation, you come out ahead.
For example, if a bond is paying 6% and the annual rate of inflation
is 3%, the bond produces real earnings of 3%. But if inflation shoots
up to 10%, the interest earnings won't buy what they once did. And
in either case, the purchasing power of the bond's par value also
shrinks unless you use it to buy another bond.
UNDER
(AND OVER) PAR
Many bonds, particularly those with maturities
of five or more years, aren't held by one investor from the date of
issue to the date of maturity. Rather, investors trade bonds in the
secondary market. The prices fluctuate according
to the interest rate the bond pays, the degree of certainty of repayment,
and overall economic conditions — including the rate of inflation
— which influence interest rates.
HOW IT WORKS
Generally, when inflation is high, interest rates
go up. And conversely, when inflation is low, so are interest rates.
It's the change in interest rates that causes bond prices to move
up or down.
If DaveCo Corporation floats a new issue of bonds offering 6%
interest, it may seem like a good investment. So you buy some bonds
at the full price, or par value, of $1,000 a bond.
Three years later, interest rates are up. If new bonds costing $1,000
are paying 8% interest, no buyer will pay you $1,000 for a bond
paying 6%. To sell your bond you'll have to offer it at a discount,
or less than you paid. If you must sell, you might have to settle
for a price that wipes out most of the interest you've earned.
But consider the reverse situation: If new bonds selling for $1,000
offer only a 4% interest rate, you'll probably be able to sell
your 6% bonds for more than you paid — since buyers will
agree to pay more to get a higher interest rate. That premium,
combined with the interest payments for the last three years, may
return a tidy profit.
The fluctuations in interest rates, and therefore in bond prices,
produce much of the trading that goes on in the bond market, as investors
try to get out of lower rate bonds or try to make profits on higher
rate bonds.
CHANGING
YIELD
Yield is what you actually
earn. If you buy a 10-year $1,000 bond paying 6% and hold it until
it matures, you'll earn $60 a year for ten years — an annual
yield of 6%, which is the same as the interest rate.
But if you buy in the secondary market, after the date of issue, the
bond's yield probably won't be the same as its interest rate. That's
because the interest rate stays the same, but the price you pay may
vary, changing the current yield.
For example, if a bond's current yield is 6%, it means your interest
payments will be 6% of what you would pay for the bond today —
or 6% back on your investment annually. But the current rate will
be higher or lower than the coupon rate, which is the rate at which
the bond was issued. You can use the current yield to compare the
relative value of bonds.
Return, on the other hand, is what you make on the investment
when the par value of the bond, your profit or loss from trading it,
and the yield are computed.
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HOW TO FIGURE A BOND'S YIELD |
| |
|
YIELD TO MATURITY
There's an even more precise measure of a bond's
value called the yield to maturity. It takes into account:
- The interest rate in relation to the price
- The purchase price in relation to the par
value
- The years remaining until the bond matures
Yield to maturity is a way to predict return
over time, but it is calculated by a complicated formula — and
it isn't often stated in bond tables. Brokers have access to the information,
and some hand-held computers can be programmed to provide it.
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