Learn the Basics of Current Bond Yields
Bonds can be a good source of investment income and are used by many investors. The first step to understanding bonds is to learn about bond yields.
Understanding bond yields
To explain how bond yields work, I’m going to use an analogy; an example using rental property.
- Let’s say you buy a house for $100,000.
- There is a renter in the house who pays $500 per month.
- Excluding any expenses you might incur, you can calculate that you will receive $6,000 a year ($500 x 12 = $6,000).
- This is a 6% annual return. ($6,000 divided by $100,000).
- Instead of a house, if you purchased a bond for $100,000, and it was paying annual interest of $6,000, we would say the bond has a current yield of 6%.
Continuing with the rental property example, assume we are entering a recession, and a major business in your town announces a layoff. You are afraid your renter might move out. The future is uncertain. You list the house for sale. Even though you still have a renter who is paying monthly rent, the best offer you receive for the house is $50,000.
The house is trading at a “discount” and reflects a bond downgrade risk. The discount reflects a value below the nominal value.
Bond Yields in Bad Economies
If someone buys your house at $50,000, and the renter stays, the new owner now gets $6,000 a year on their $50,000 investment. Their current yield is 12%. ($6,000 divided by $50,00) They get a higher return because they were willing to take the risk of buying a stream of income in uncertain times.
If the house were to appreciate to $100,000, it would no longer be discounted and the current yield would reduce back to 6% assuming the rent stays the same.
When a company does not pay interest on its bonds, it is said to be in default.
Bonds will trade at a discount (meaning below their face value) when there is a greater risk that some of the companies will go out of business and thus may default on their bonds.
This concern affects the market price, not the "rent."
In the example we've used, if the renter misses a payment, the current yield becomes 0%.
Bond Interest Income Is More Secure Than Dividend Income From Stocks
A company must pay interest on its bonds before it pays dividends on its stock, so, during uncertain times, your future investment income is more secure if you own an interest paying bond instead of a dividend paying stock.