The Federal Reserve, in keeping with its dual mandate of pursuing full employment and stable prices, has been conducting aggressive monetary policy driving interest rates to historically low levels. This action by the Fed has resulted in large gains in bond prices. As such, most bonds are now trading at what is referred to as a "premium".
Premium bonds are misunderstood by the retail investor who typically focuses their attention primarily on the dollar price of the bond as opposed to its yield. Bonds are normally issued in $1,000 face value increments. A bond selling at below face value is said to be selling at a "discount". A bond selling at its face value is said to be selling at "par", and a bond selling for more than its face value is said to be selling at a "premium". Do not confuse these terms (discount, par, premium) with degrees of quality or value. A bond selling at a premium does not necessarily make it better or for that matter more expensive on a relative basis than a bond selling at par or a discount. Those terms are only used to describe the bond's current price relative to its face value.
So, if the dollar price of a bond really doesn't express its relative value, how can an investor compare bonds? That answer may lie in the bond's yield. A bond's yield takes into consideration a bond's price, the maturity, and the coupon rate. Yield is an extremely important concept in bond investing that is typically overlooked by retail investors, who make value judgments by solely focusing on the bond's dollar price. Yield is an important tool to measure the return of one bond against another (other things being equal, like credit ratings, call features, and/or the bond's maturity date). In essence, "yield" is the rate of your return on your bond investment. Professional bond dealers and traders, when buying and selling bonds to one another, usually quote bond prices in yields not dollars; yield gives you an immediate look into the bond's relative value compared to other bonds. When looking at yields, here are some useful tips to search for value:
- Compare the yield of the bond you are considering to other similar investments. Bonds are not as liquid as stocks and many times you can find value by comparing.
- When evaluating various maturities of the same bond, look at the incremental yield (the spread) you would be receiving by investing in the longer maturity and make sure you feel it's worth the extra risk. Yields are quoted in basis points: 1 basis point is 1/100th of one percent; 100 basis points is equal to 1%. For instance, if you are comparing a 15 year bond with a 30 year bond, and the 30 year bond yields only 5 basis points more, that is probably not worth the extra risk.
- Higher rated bonds will usually offer a lower yield, other things being equal. If you are evaluating a lower rated bond, make sure the extra yield you would get (the spread) with the lower rated bond is worth the extra risk.
- Don't get caught up in a specific maturity date. Due to the way bonds are traded, it's very possible to get a bond with a shorter maturity that offers better value, other things being equal.
- In this interest rate environment, consider investing in higher coupon bonds (Premiums) which are usually more defensive should interest rates rise earlier than anticipated. But keep in mind that if interest rates remain as is or go lower for a longer period of time, bonds with call features may be redeemed earlier than what you had anticipated.
To become a wiser bond investor, start paying more attention to a bond's yield as opposed to its dollar price. And don't be surprised to see a bond selling at a premium giving you more value (yield) than a bond selling at a discount.