Investing in Bonds 101: Terminology (cont.)
Part 2 or 3, page 2
Calculating Bond Yields
Having covered the fundamental terminology, you are now ready to calculate bond yields. There are only two pieces of information you need to calculate yields - the coupon rate and the initial value or par value for the bond. Example, if you purchased a bond for $1,000 which paid $50 a year in interest then the current yield is calculated this way:
Current Yield = $50 / $1,000 = 0.05 or 5%
Some of you might be wondering why we didn't just tell you to look at the coupon rate to figure out the bond yield, it is not that simple.
Bond Yields and Coupon Rates
A bond issuer normally attempts to structure a bond offering such that the bond sells on the market at a price that is fairly close to its par value. So in issuing a bond takes into consideration several things in establishing its coupon rate:
+ The interest rate curve – this is the direction interest rates are thought to be taking (long and short term interest rates) between the date of issue and maturity date.
+ The associated risk - the issuing entity or the possibility of default or non payment of interest on a bond, or the return of the initial investment to its bond holders. (This has happened in the past – investors looking for high returns lost everything when a South American country defaulted.)
+ Bond redemption features – this can be used to mitigate risk to either the investor or the issuing company.
As time passes, these three variables change. This means the current price of a bond might go lower or higher than its par value.
Next, bond redemption and credit quality.>>>
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