By Nicholas Gliagias and Rom Badilla, CFA
Investors look to bonds for the income they earn over time and because they are generally safe investments. Given today’s environment, bonds are an integral part of an investor’s allocation. Hence, we receive a lot of questions on the proper way to look at bonds. The one thing we noticed is that many investors tend to focus a lot on just the coupon, or the amount of interest that they will be earning during the life of the bond. While vital, it is important to realize that there should be more emphasis placed on the bond’s price as it may provide better clarity on your return on investment.
With a bond investment, you know the future cash flow, which are both the coupon and the redemption value when the bond matures. When you are purchase a bond, you are quoted a price of the bond which is essentially what you are paying to receive those cash flows. With these three ingredients you can determine your expected return from the investment. This can be accomplished by looking at the Yield to Maturity measure.
The yield to maturity is the annualized return on your bond if certain conditions are met. One of the most important is that the bond will need to be held until maturity. The yield to maturity incorporates not only the coupon rate over time and return of principal, but also takes into account the price of the bond. In other words, the yield incorporates the price that an investor is paying to receive those future cash flows. Since the price of the bond will change over time as supply and demand for bonds fluctuates, so will the yield to maturity.
That is why it is very important to place emphasis on the bond’s price and hence the yield to maturity and not just at the coupon. For example, imagine that you have two bonds:
- Bond A – Face Amount: 1000, Coupon: 7%, Years to Maturity: 10, Price: $100
- Bond B – Face Amount: 1000, Coupon: 10%, Years to Maturity: 10, Price: $130
At first glance, it may seem that Bond B is the better bond to hold because Bond B has a higher coupon rate than Bond A. However, this does not necessarily mean that Bond B will earn a greater return than Bond A. We have to remember that the bond price of Bond A is lower than the bond price of Bond B, which has a greater impact than the coupon rate on the yield to maturity. In our example, the yield to maturity would be 7% in Bond A and 5.38% in Bond B. Bond A has a greater annualized return than Bond B due to the fact that Bond A’s price is less than Bond B’s price. The fact that Bond B had a higher coupon rate than Bond A played less of a role as the bond price did in this example. So an investor who is focused solely on the coupon by choosing Bond B would have left chips at the table and will have earned less as evident by the Yield to Maturity calculation.
This exercise shows that there should be a greater focus placed on bond prices and yield to maturity rather than just on the coupon. Of course looking at the coupon can also be very helpful in determining your fixed income stream. Ultimately it will be the price of the bond, the coupon rate, and the length of time of those cash flows that will impact your yield to maturity or rate of return which is what matters most to investors. At the end of the day you want a higher yield to maturity, even if it means earning less income from the coupon payments.
Disclaimer: The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.