Last week we discussed basic concepts and terminology regarding bond investments. Recall that bonds represent fractional participation in loans made to corporations, municipalities and even sovereign nations. A bondholder is promised a certain fixed amount upon maturity, and periodic interest payments at intervals along the way. The anticipated or expected rate of return is a function of time to maturity as well as risk of non-payment.
Today we will walk through an example of how bonds are priced in the market. It is this aspect that is perhaps least well understood by investors.
Consider a bond issued yesterday by Johnson and Johnson. It has a 2.5 percent coupon rate, AAA credit rating, and matures in 10 years at a face (par) value of $1,000. At the time of issue, the market interest rate was also 2.5 percent for bonds of this quality.
How much would you invest today to receive $1,000 ten years from now? Presumably less than $1,000, since you must be compensated for inflation and receive some modest reward for your trouble. On average, investors are currently willing to accept 2.5 percent annually for this exchange, so the par value must be reduced or “discounted” such that the final payment results in an annual return of 2.5 percent. A simple computation yields a present value of $780. Investors will pay $780 today to get $1,000 in 10 years as long at interest rates remain at 2.5 percent.
Christopher HopkinsFor some bonds, that’s the extent of it. “Zero coupon” bonds make no payments along the way but can be purchased at a deep discount. This is exactly how U.S. Savings Bonds operate, and this type of instrument can be useful in matching long-term liabilities like estimated tuition payments years in the future.