The numbers that matterSunday, August 01, 2021
BY TONI-ANN NEITA-ELLIOTT
Bonds are fixed-income investments that many investors use for a steady stream of income, especially during retirement. When buying a bond there are two critical numbers that you will encounter — the coupon rate and the yield. It is important to understand the difference between these two numbers, what they represent and why they are important.
A bond has a variety of features when it's first issued, including the size of the issue, the maturity date, and the initial coupon. A bond's coupon rate is the rate of interest that the issuer pays bond holders per year. It can be paid quarterly, semi-annually, or yearly depending on the terms of the bond and is calculated on the amount of the bond that you own, which is known as the face value.
Bonds trade in the open market after they're issued. This means that this bond's actual price will fluctuate over its life. The price you pay for an already issued bond is usually higher or lower than the face value or “par” value. When a bond sells for more than its face value, it sells at a premium. When it sells for less than its face value, it sells at a discount.
Irrespective of the change in the price of a bond, the coupon rate will remain fixed for the life of the bond. Even if the bond price goes drastically up or down, your payment amount will stay the same. That's why many retirees like having bonds. They can count on the steady income based on the coupon rate and how much face value of the bond they hold.
Yield to maturity (YTM) is what the investor can expect to earn from the bond if they hold it until maturity. In other words, it is the effective rate of return of a bond.
So how can your earnings from a bond, the “yield”, be different from the coupon rate? That is because there is the potential gain or loss generated by variations in a bond's market price. The yield to maturity calculation incorporates the potential gains or losses generated by those market price changes.
If an investor purchases a bond at par or face value, the yield to maturity is equal to its coupon rate. If the investor purchases the bond at a discount, its yield to maturity will be higher than its coupon rate. A bond purchased at a premium will have a yield to maturity that is lower than its coupon rate.
That sounds simple enough, but why is that? Think of it like this, if you have to pay more to get the same face value of a bond then that reduces your overall return on the investment because your initial investment (initial spend) is more than the face value, but you only receive interest on the face value amount. If you pay less than the face value of the bond, you will still get interest on the face value amount and you will get back that face value amount at maturity even though you didn't pay that amount for the bond. The yield in that scenario is higher than the coupon because you get the coupon interest payments plus a little “brawta” at the end. For the non-Jamaicans reading this, brawta refers to a bonus or getting something extra. An example may better help to illustrate this.
Example: You purchase US$10,000 face value of a five per cent 10-year bond and received US$500 interest payments per year (ie, five per cent on US$10,000). If you paid US$10,000 for the bond, then both your coupon rate and yield will be the same five per cent. If you paid US$11,000 for the same bond, then the yield will be less than five per cent because you paid an extra US$1,000 for the bond but will still only received US$500 per year for the remaining life of the bond since you only own US$10,000 face value of the bond even though you paid more. It will take you two years to overcome the additional US$1,000 you paid, therefore reducing your overall return on your investment. If you paid US$9,000 for the same US$10,000 face value of the bond, you will receive US$500 per year in interest plus you will received US$10,000 at maturity (an extra US$1,000) even though you only paid US$9,000 upfront, and so your yield will be higher than the five per cent.
In conclusion, coupon rates and yield are very important components of a bond for an investor. Each should be taken into consideration when buying a bond in order to decide which bond is right for you. If your focus is income, then the coupon rate is the more important number for you as it will determine how much cash you will get in hand each year from your bond investment. However, you should not ignore the yield as it will tell you what you will really earn on your investment, based on what you spent upfront, the amount of interest you will earn and the amount of principal (face value) that you will get back at maturity.
Toni-Ann Neita-Elliott, CFP is the Vice-President, Sales & Marketing at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm
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