You can add bonds to your investment portfolio to provide stability. That's because bonds are known to be safe investments. When you invest in bonds, you're providing a steady stream of income in times when your stocks may perform poorly. Bonds are a great way to protect your savings when you don't want to put your assets at risk.
Learn more about the features of bonds and how to find the yield to maturity.
Key Features of Bonds
Most bonds have five features when they are issued: issue size, issue date, maturity date, maturity value, and coupon. Once bonds are issued the sixth feature appears, which is yield to maturity. This becomes the most important figure for estimating the total yield you will receive by the time the bond matures.
Issue Size and Date
The issue date is simply the date on which a bond is issued and begins to accrue interest. The issue size of a bond offering is the number of bonds issued multiplied by the face value.
For instance, let's say an entity issues two million bonds with a $100 face value. That means the issue size is $200 million dollars. The issue size reflects the borrowing needs of the entity issuing the bonds. It also shows the market’s demand for the bond at a yield that’s acceptable to the issuer.
Maturity Date and Value
The maturity date is the date on which you can expect to have your principal repaid. It is possible to buy and sell a bond in the open market prior to its maturity date. Keep in mind that this changes the amount of money the issuer will pay you as the bondholder based on the current market price of the bond.
Bonds trade on the open market from their date of issuance until their maturity. That means their market value will typically be different from their maturity value. You can expect to receive the maturity value at the specified maturity date barring a default. This is true even if the market value of the bond fluctuates during the course of its life.
Coupon and Yield to Maturity
The coupon rate is the periodic interest payment that the issuer makes during the life of the bond. For instance, a bond with a $10,000 maturity value might offer a coupon of 5%. Then, you can expect to receive $500 each year until the bond matures. The term “coupon” comes from the days when investors would hold physical bond certificates with actual coupons; they would cut them off and present them for payment.
The actual yield you would receive if you purchased a bond after its issue date (the yield to maturity) is different from the coupon rate. This is because bonds trade on the open market.
Yield to maturity is a calculated estimate of the total amount of interest income a bond will yield over its lifetime. This is the value that most bond investors worry about.
Example of a Bond's Yield
As an example, we'll start with the dollar amounts from above. Let's say that a company issues 10-year bonds with a face value of $10,000 each and a coupon of 5% annually. In the two years following the bond issue, the company's earnings rise. This adds cash to its balance sheet and provides it with a stronger financial position. All else equal, its bonds would rise in price, say to $10,500; the yield would fall because prices and yields move in opposite directions.
The coupon would remain at 5%. This means that investors would receive the same $500 payment each year. But investors who purchased the bond after it had already risen in price might receive different yields to maturity (YTM). It all depends on the price they bought the bond at.
Be cautious of online YTM calculators and easy formulas. They are often inaccurate. Some financial advisors even confuse YTM with a bond's current value.
The formula for calculating yield to maturity uses the bond's coupon, face value, current price, and the number of years it takes to mature.
YTM = ( C + ((FV - PV) ÷ t)) ÷ ((FV + PV) ÷ 2)
- C: Interest or coupon payment
- FV: Face value of the security
- PV: Present value or price of the security
- t: How many years it takes the security to reach maturity
To calculate our bond's YTM:
=($500 + (($10,000 - $10,500) ÷ 10)) ÷ (($10,000+ $10,500) ÷ 2)
=($450) ÷ ($12,500)
=.036, or 3.6%