Bonds

A bond is basically a financial instrument by which a certain amount of money, in a certain currency, for a specified period of time, is borrowed and for which a specified percentage of interest is being paid each year. The percentage expressing the interest that is being paid is also called the coupon.

As for shares bonds may be traded at exchanges so the market value - or quote - may deviate from the face value.

Example: A bond may be issued at face value. Let's assume the face value is $1,000. This is the amount of money that will be paid back upon the due date of the bond. The coupon is 5%. So each year this bond will pay interest of $50.00 [1]. This interest results in a yield of 5% as well.

At some point the bond might be traded at the exchange at 98%. This means that you can buy the bond for $980. As you would still get the same interest of $50 the yield would be 5.10% (100% / $980 * $50).

On the other hand the bond price might go up to let's say 104%. Again the interest stays the same at $50. As you paid $1,040 for the bond the yield would then be at 4.81%.

When the actual quote for the bond is different from the face value, AND you keep the bond until it expires then you also gain (or loose) that difference.

Example: With the above example when you buy the bond at 98% then you would also get the 2% difference (= $20) when the bond expires and the borrower pays back his/her debt. Let's assume that when you buy the bond it expires two years later. The difference in price (= $20) results in additional capital gains of $10 per year. So your actual yield would be: 100% divided by $980 multiplied by the total return (interest and capital gains per year) of $60 ($50 + $10) resulting in 6.12%.

Again with the above example but this time assuming the quote is 104% for our bond and the remaining time until expiry is 4 years. The total return per year will be the interest ($50) plus the loss of $40 in total or $10 per year. The total return per year will therefore be $50 - $10 = $40. Having paid $1,040 the yield therefore would be: 100% / $1,040 * $40 = 3.85%.

What we see is that a change in the price (quote) of a bond has two affects. Generally the longer the time until expiry the smaller the impact on the yearly yield.

Related Topics

• Zero Bonds

[1] For illustration purposes tax will not be considered in order to keep the example simple.