Watch our animated videos to learn the basics of investing in bonds.
Exploring price and yield
This animated tutorial explores the basics of how bond works.
Essentially, a bond is an ‘IOU’ made up of three parts which are: how much is owed – in other words, how much the IOU holder should get back. When that amount is due to be paid and how much interest will be paid in the meantime. Simple!
When it comes to bonds, they call these three things: The face value or ‘par’ value, the ‘redemption date’ and the ‘coupon’.
So, the basic outline of a bond, issued by the UK government for example (more on this later), might look something like this:
So, if an investor bought this bond on January first, twenty-fourteen at face value – and holds it until it matured on December thirty-first, twenty-eighteen – they would get four pounds fifty per year for five years, then get their one hundred pounds back.
In reality it’s a bit more complicated than that. These IOUs called ‘bonds’ trade in markets, and for a variety of reasons we’ll explore later, they almost never trade at their face value.
If a bond is trading above its par value, for example, it’s trading at a premium, but if the opposite is true, it’s at a ‘discount’.
If an investor buys the bond above for ninety five pounds – a discount of five pounds on its face value – and holds it until maturity --they would get still get the twenty two pounds fifty in coupon payments. Plus they would also get one hundred pound par value back, for a profit of five pounds. Of course they would lose five pounds if they bought the bond for a premium of five pounds over par, for example; one hundred and five pounds.
And don’t forget, you don’t have to hold the bond all the way to maturity. Investors also buy and sell bonds, so if the price goes up they can always sell it and realise a gain.
A bonds return includes all of the interest it pays and any difference in price between what you paid for it and what you receive when you sell or redeem it.
Because bond prices fluctuate relative to their face value, bond returns can appear complex and daunting.
But if you keep this basic framework in mind it can all make a lot more sense.
This total return is called the ‘gross redemption yield’. It only provides a rough and ready measure of the total value of a bond if you bought it at a given price and held it all the way to redemption. Just remember that it doesn’t take account of any taxes, the effects of inflation or what would happen if you sold the bond early.
Another rough measure of a bond’s value is called the ‘income yield’. It gives you a simple way of roughly comparing the yields of bonds that have different prices and coupons.
You’ll also sometimes hear this referred to as the ‘running yield’, or ‘current yield’.
To get the current yield you divide the current market price by the bond’s coupon. It tells you what a bond would pay you over one year at its current market price.
Remember that the coupon stays stable throughout the bonds life, while the price varies.
Let’s look at some examples.
Here are two hypothetical bonds.
Both have a face value of one hundred pounds, which the investor would get if they held the bond to its redemption date.
Bond A is trading at ninety four pounds and has a coupon of four per cent. With a face value of one hundred pounds, that’s four pounds.
Bond B is trading at ninety nine pounds and has a coupon of four point five per cent, or four pounds fifty.
Dividing the market prices by the bond’s coupons and you get their current yield.
As you probably noticed, this measure doesn’t take account of the bond’s term. In other words, current yield only allows you to compare what two bonds will pay each year. It doesn’t reflect how long the bonds will pay that amount.
We’ll take a look at that in a later section.
Investment risk information:
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.
Other important information:
This video was produced by Vanguard Asset Management, Ltd. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.
If this is to be used on third party websites for an audience of professional investors as the submission suggests I would also include the for professional investors disclaimer at the top.
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.
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