Bonds – Understanding Yields And Returns

So, you are at the point where you are considering the purchase of some bonds. As an investor, one determinant of what you purchase should be the yield you may expect from your investment.

There are basically 3 types of yields that would interest the average investor. These are the coupon yield, the current yield and the yield to maturity.

Understanding The Coupon

The coupon is usually the easiest of the three yields to understand. It relates to the interest rate an investor receives on the face value of his investment and is set by the issuer of the bonds. If you’re accustomed to dealing with money market instruments, here’s a comparison that will make this even easier to understand: In the Money market, investors are usually quoted a rate that represents the actual cash that will be received on the total amount of money invested. The equivalent rate in the Bond market is the Coupon, but it relates only to the face value of the bonds. 

So, the Government of Jamaica has issued its 2007 Bonds with a coupon of 12.75%, payable semi-annually. The interest payments are calculated on the face amount of the bonds. If the investor buys US$50,000 face value of bonds at a price of 115, he would pay US$57,500 (i.e. 50,000 x 115/100) for the bonds, inclusive of a premium of US$7,500 (i.e. 50,000 x 15/100). His interest payments would be US$6,375 per annum (i.e. 50,000 x 12.75%) or, for six months, US$3,187.50 (i.e. half the annual amount).

Why is the coupon of interest to an investor? Because this determines the actual amount of interest the investor receives on the bonds from the issuer. The investor will use this, in planning his cash flow, to determine how much he will actually get from an investment at a particular point in time. The coupon is usually fixed for the life of the bond and will not change while the investor holds the bond.

Understanding the Current Yield

The current yield represents an effective yield. It tells the investor what percentage he is expected to earn on his total investment if he were to sell the bond at the same price at which it was bought. The current yield is calculated by dividing the coupon by the price paid for the bond. For example, the current yield on the GOJ 2007 Bond mentioned above would be 11.087% (i.e. 12.75 divided by 115, if the bond were selling at a price of 115). The same rate would be found by dividing the coupon amount (US$6,375) by the total investment (i.e. US$57,500).

How does an investor use this current yield information? For shorter investment periods of say a year or so, investors may be more concerned about a bond’s current yield - particularly if the bond’s price is not expected to fluctuate significantly during the holding period. Given a choice between two similar bonds, the short-term investor would favour the one with the higher current yield.

Some more sophisticated investors – e.g. project investment managers - use the current yield as a tool in making investment decisions. They often use it as a means of choosing between different short-term investments or when deciding whether to invest in a particular bond or to plough back profits into their company. The current yield is the rate they would use to compare with their company’s Return On Investment (ROI).

Understanding the Yield to Maturity

The calculation of the yield to maturity is a little difficult to understand but the concept is extremely important for long-term investors. Because of the complicated nature of the calculations, which will take us into present value concepts, we will look here only at the value of the concept itself and reserve the mechanics of the calculations for the classroom.

The yield to maturity is the effective return an investor will receive if he holds the bonds to maturity. It represents his total income from his investment as a percentage of his investment, discounted over the life of the investment. Some of you will ask why the income is being discounted. Others of you, who have already met the “present value” concept, will answer by explaining the time value of money: One dollar in 10 years time will certainly buy less than it would buy today! Therefore, today’s dollar is worth more than a dollar in 10 years’ time. This means that if today’s dollar were to be made equal to a dollar in 10 years’ time, today’s dollar would have to be discounted.

What does this have to do with the yield to maturity? Remember that the yield to maturity is the effective return during the life of the investment. The fact that the investor is getting a 12.75% coupon (in cash – great return!!) on his investment might be little consolation if that investor paid a substantial premium on the investment. The yield to maturity takes this premium into consideration and gives the investor a percentage return that is easily understood and which he can compare to yields on other investments over the same time period.

The important thing for the investor to remember here is that if the investment is for the medium to long term, the yield to maturity yardstick is the best measure of the effective return on the investment.

By Pamela Lewis-Chambers