The Fed laid an egg last week in punting on a long-awaited rate hike, causing bonds to rally while stocks sold off on the news. Understanding the interplay between interest rates and various investment classes is clearly useful in balancing risk in an investor's portfolio. And since no asset class is more directly impacted by changing rates than bonds, a refresher course is in order.
Bonds are really nothing more complicated than loans to companies, governments, and municipalities that pay the investor a stated interest rate and return principal at maturity. Yet while bonds are relatively simple and highly determinant, many people express a lack of understanding and comfort with the mechanics of bond investing.
A few vital keys to understanding bonds include maturity, credit quality and the various measures of "yield."
Chris Hopkins of Barnett & Co.Maturity is straightforward. This is the date upon which the holder will receive the full face value of the bond (barring a bankruptcy). The face value is typically $1,000 for corporate issues, so a holder of 10 bonds would receive $10,000 at maturity.
Credit quality measures the likelihood that the borrower will be able to cough up the face value on the appointed maturity date. Issuers often subscribe to rating services like Standard and Poor's or Moody's, who assign a credit rating that attempts to quantify repayment risk. For S&P, bonds are considered "investment grade" if their rating falls within BBB to AAA.
Yield is more ambiguous and must be carefully defined. "Coupon yield" (or stated yield) is the original interest rate at which the bond was issued. This determines the actual cash payment an investor will receive each year. Suppose a bond issued today by CVS Health carries a 4 percent coupon and matures in 2025. An investor would pay $1,000 and receive 4 percent, or $40 per year in interest, for 10 years, and then be repaid the $1,000 face value. So far, so good.
Now imagine that a year passes and interest rates rise by 1 percentage point. Another investor notices the CVS bond can now be purchased for less than face value, $929 to be precise. Why? Because the bond pays only $40 per year in interest, which is less than the new market rate of 5 percent. A brand new $1,000 bond would pay $50, so the old bond must be marked down or "discounted" to compete with a shiny new 5 percent issue.
The second measure of yield compares the interest payment to the purchase price, and is called the "current yield" or cash yield. The current yield is the cash payment of $40 divided by the purchase price of $929, or 4.3 percent. By definition, the current yield of a brand new bond sold at par equals the coupon yield.
The astute reader observes that our new investor can realize a $71 capital gain by buying the discounted bond and holding to maturity to capture the face value. A more comprehensive definition of yield should incorporate this capital gain. We call this measure the "yield to maturity" defined as the annualized total return from all interest payments, reinvestment of interest, and net capital gains. Bonds purchased at a premium would impart capital losses.
The yield to maturity is the actual market rate of interest that can be observed in the marketplace. Here the YTM is 5 percent: we can either buy a new issue 5 percent coupon bond or pick up a discounted year-old 4 percent coupon, but either way our annual return will be the market rate of 5 percent. This is the best estimate of an investor's actual expected return over the life of the bond.
See, not so complex after all.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co., in Chattanooga.