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How much can I earn/lose?
It depends.
If you just want to buy and hold to maturity:
Buying and holding a bond to the maturity date, will probably not produce large returns or losses. They will certainly earn more than the interest earned from leaving cash in a bank. And, short term bonds can beat the stock market if the country is having economic problems. However, in any extended period of time, equities usually outperform bonds. Furthermore, inflation can diminish returns if the bond does not contain a floating interest rate.
If you want to trade bonds.
Like any trading, the profits and losses can be much larger. Investors pursuing bond trading should understand the following concepts.
1. Federal Interest Rates and Inflation
Generally, when inflation is up, the Fed raises interest rates. When inflation is low (or deflationary pressures exist), interest rates are low.
The changing interest rates are one of the main factors driving bond price changes.
If interest rates drop, bonds bought under the higher interest rates become more valuable than new bond issues. Buying bonds at market price above the original face value of the bond is called 'Buying at a Premium'
If interest rates rise, bonds bought under the previously lower interest rate become less valuable. Buying bonds at market price below the original face value is called 'Buying at a Discount'.
The changing desire for bonds based on inflation rate moves is core to bond price changes
Suppose Joe Investor buys a bond at 10%. If interest rates drop to 5%, the price investors are willing to pay will be significantly higher than the principal returned at maturity. In this respect it is possible to make money on the capital appreciation of bonds during a declining interest rate environment.
2.Yield is NOT the same as the interest rate (coupon rate)
The interest rate and par value are set at the initial purchase of the bond, and never change. The Yield is what the investor actually earns off the issue. More preceisely, the yield measures the interest earnings relative to the actual price paid by the investor.
The formula for calculating yield is:
yield = annual interest received / price paid
Time for another easy example
| Buy Case |
Buyer |
Return |
Yield |
At Par
- Market Price
- $1,000
- Par Value
- $1,000
- Term
- 20 years
- Interest Rate
- 6%
|
- Buy bond at par value, hold until maturity
- Receive 20 annual payments of $60
- Receive par value of $1,000 at maturity
|
- Par Value
- $1,000
- Interest:(x20)
- $1,200
- Earnings
- $2,200
- original cost
- -$1,000
- RETURN
- $1,200
|
$60 / $1000 = 6% |
At Discount
- Market Price
- $800
- Par Value
- $1,000
- Term
- 20 years
- Interest Rate
- 6%
|
- Buy bond at market price, hold until maturity
- Receive 20 annual payments of $60
- Receive par value of $1,000 at maturity
|
- Par Value
- $1,000
- Interest(x20)
- $1,200
- Earnings
- $2,200
- original cost
- -$800
- RETURN
- $1,400
|
$60 / $800 = 7.5% |
At Premium
- Market Price
- $1,200
- Par Value
- $1,000
- Term
- 20 years
- Interest Rate
- 6%
|
- Buy bond at market price, hold until maturity
- Receive 20 annual payments of $60
- Receive par value of $1,000 at maturity
|
- Par Value
- $1,000
- Interest(x20)
- $1,200
- Earnings
- $2,200
- original cost
- -$1,200
- RETURN
- $1,000
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$60 / $1,200 = 5% |
This chart shows that as with all other trading activities, buying at a discount returns the most profits. Discounted purchases will have the highest yields. Conversely, lower yields indicate lower potential earnings.
3. Now forget yield, it is all about Yield to Maturity
Yield to maturity (YTM) is the most accurate way of measuring the true total returns of a bond product. Not only does it take into account interest rate and price, but it also factors in market price vs face value and years remaining until the bond matures. Sound confusing? Don't worry. While the formula for calculating yield to maturity is extremely complicated, bond charts generally list the yield to maturity value.
Yield to Maturity is the first measure to consider when comparing bonds!!!
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