Understanding bonds

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owenmia
Posts: 53
Joined: Mon Jun 24, 2019 10:19 am

Understanding bonds

Post by owenmia » Wed Jul 10, 2019 2:47 pm

When I buy a bond, do I get the "coupon rate" or the Yield to Maturity". I bought these bonds understanding I would earn 4% (the coupon rate) but I am being told I will actually be earning 2% (the yield to maturity".

Company Altera (Intel)
yield to maturity 2.10%
Maturity date 2023
Coupon rate 4.10%


Union Pacific 907818DK1
Yield to Maturity 2.17%
Maturity Date 2022
Coupon Rate 4.163%

123
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Re: Understanding bonds

Post by 123 » Wed Jul 10, 2019 2:54 pm

If the yield to maturity is less than the coupon rate it means that you paid a premium (more than maturity value) for the bond. The premium that you paid over the maturity value of the bond is amortized over the remaining life of the bond so it brings down the interest rate. However your account will still be credited with an interest payment based on the coupon rate when the periodic interest payments are paid. In effect you get back a little of the premium you paid when you bought the bond with each interest payment.

The initial issuer of the bond has no idea what secondary purchasers of the bond may have paid for it. They only sold bonds based on the coupon rate which is what they base their interest payments on. Over the life of the bond and multiple purchasers it's quite likely that every purchaser has a different purchase price and yield to maturity based on their own purchase date.

Your purchase price for the bond likely included a premium for the interest rate as well as a payment to the person you bought it from for the interest that had accrued on the bond since the last interest payment was made by the issuer of the bond. You had to pay the accrued interest on the bond because the next full interest payment (for six months) will be paid to you as the owner of the bond by the issuer.
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Kevin M
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Re: Understanding bonds

Post by Kevin M » Wed Jul 10, 2019 3:33 pm

owenmia wrote:
Wed Jul 10, 2019 2:47 pm
When I buy a bond, do I get the "coupon rate" or the Yield to Maturity". I bought these bonds understanding I would earn 4% (the coupon rate) but I am being told I will actually be earning 2% (the yield to maturity".
<snip>
Union Pacific 907818DK1
Yield to Maturity 2.17%
Maturity Date 2022
Coupon Rate 4.163%
Since you provided the CUSIP for this one, I looked it up. Maturity is 7/15/2022, but it is callable at 100 on 4/15/2022, so you may be quoting yield to worst (call date) rather than yield to maturity. for the given yield of 2.17%, assuming that's YTW, so called on 4/15/2022, and assuming the purchase was settled today, the bond price would be 105.32. That means you would pay 1,053.20 per bond (plus accrued interest).

Since the bond will mature or be called at 100, the loss of 5.32 over the term to maturity is factored into the yield to maturity. That's why your yield is 2.17%, even though the coupon is 4.163%.

I don't know why you'd buy an A-/Baa1 rated 3-year bond at 2.17% when you could get an FDIC-insured 3-year brokered CD at 2.15%, or a 3-year direct CD at close to 3%.

Kevin
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22twain
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Joined: Thu May 10, 2012 5:42 pm

Re: Understanding bonds

Post by 22twain » Wed Jul 10, 2019 5:19 pm

owenmia wrote:
Wed Jul 10, 2019 2:47 pm
When I buy a bond, do I get the "coupon rate" or the Yield to Maturity".
Both. Or either one, depending on what exactly you mean by the word "get." :wink:

The dollar value of your interest payments is determined by the face value (par value) of the bond and the coupon rate. For example, if you have an Altera bond with a face value of $10,000, you will get $10,000 x 4.10% = $410 per year.

If you keep the bond until it matures, you will get its face value, $10,000, at that time. This is incorporated into the the yield to maturity, in a negative way because you paid more than the face value when you bought the bond. Therefore the YTM is less than the coupon rate.
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dbr
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Re: Understanding bonds

Post by dbr » Wed Jul 10, 2019 6:02 pm

22twain wrote:
Wed Jul 10, 2019 5:19 pm
owenmia wrote:
Wed Jul 10, 2019 2:47 pm
When I buy a bond, do I get the "coupon rate" or the Yield to Maturity".
Both. Or either one, depending on what exactly you mean by the word "get." :wink:

The dollar value of your interest payments is determined by the face value (par value) of the bond and the coupon rate. For example, if you have an Altera bond with a face value of $10,000, you will get $10,000 x 4.10% = $410 per year.

If you keep the bond until it matures, you will get its face value, $10,000, at that time. This is incorporated into the the yield to maturity, in a negative way because you paid more than the face value when you bought the bond. Therefore the YTM is less than the coupon rate.
Excellent answer. You correctly point out that one does not actually "get" a yield even though, as you say, we call it that. One gets the interest payment of $410/year and one gets $10,000 when the bond matures. Everything else is just mathematical formulas that are configured to report different ways of looking at those facts. We could add another one, which is that if the bond were sold today one would get market price to sell the bond less any spreads and costs and from that one could configure a calculation of what return this investor obtained from that holding. But again the "get" would be the cash realized and not some derived number.

22twain
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Re: Understanding bonds

Post by 22twain » Wed Jul 10, 2019 9:34 pm

I suppose it would be more accurate to say that the difference between the face value and the price you paid for the bond is what gets incorporated into the yield to maturity. If you paid a premium over face value (because the coupon rate is higher than current interest rates), you don't get all of the purchase price back at maturity, which effectively subtracts from the value of the coupons that you've collected. If you bought the bond at a discount from face value (because the coupon rate is lower than current interest rates), you get more than your purchase price back at maturity, which adds to the value of the coupons that you've collected.
My investing princiPLEs do not include absolutely preserving princiPAL.

bondsr4me
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Re: Understanding bonds

Post by bondsr4me » Thu Jul 11, 2019 7:38 am

To help you understand bonds, I strongly suggest you get this book:

"Bonds The Unbeaten Path to Secure Investment Growth" by Hildy and Stan Richelson.

They explain the many different bonds.

I hope you find it very helpful.

Don

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Sandtrap
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Location: Hawaii No Ka Oi , N. Arizona

Re: Understanding bonds

Post by Sandtrap » Thu Jul 11, 2019 9:07 am

Some resources for you:

The Only Guide to a Winning Bond Strategy You'll Ever Need: The Way Smart Money Preserves Wealth Today : Swedroe
https://smile.amazon.com/gp/product/031 ... UTF8&psc=1

The Bond Book, Third Edition: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More: by Thau
(a favorite of mine)
https://smile.amazon.com/gp/product/007 ... UTF8&psc=1

j
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