Small Business Taxes & ManagementTM--Copyright 2021, A/N Group, Inc.
There are two basic measures of a return on bonds (and other fixed income investments). Once is current yield; that's simply the stated yield or the annual coupon payment divided by the price of the bond. A bond purchased for $1,000 that pays $50 per year has a current yield of 5 percent.
The second measure is the yield to maturity. This yardstick takes into account the fact that you might pay more (a premium) or less (a discount) than the face value for the bond. Finding the yield to maturity requires discounting that premium or discount. The computations are easier today, but you'll need a financial calculator or spreadsheet program or an online calculator. The yield to maturity is the same as the current yield only if the purchase price is equal to the amount you'll receive at maturity. And that's rarely the case.
Example--A bond with 10 years to maturity and an 11% coupon ($110 of interest annually) may be purchased for $1,150. The current yield is 9.56 percent ($110 divided by $1,150). But the yield to maturity is only 8.69%. That's because at maturity you'll only receive $1,000. In effect, the $150 premium you pay for the bond reflects the higher current yield. Even if market interest rates remain the same, as the bond approaches maturity a buyer would pay you less each year since at maturity he will never get more than $1,000. The tax laws recognize this and generally allow you to take an annual deduction (amortize) any bond premiums.
If the bond is selling below the value at maturity (at a discount), your yield to maturity will be higher than the coupon amount because you're not only getting the coupon amount every year but also will get the full face amount of the bond at maturity.
The only major risk with buying bonds at a premium is that some bonds are callable. That's particularly true for municipal bonds. If the bond is called you may lose part or all of the premium you paid. Otherwise, two bonds with the same yield to maturity are equal (assuming the same quality, term, tax factors, etc.). Many, but not all, bonds, taxable and tax-exempt, are callable. The call price is set when the bonds are issued. For example, Madison County issues a bond with a 5 percent coupon maturing in 2040. The bond is callable no earlier than 2030 at a price of $1,050. When the bond reaches 2035 it may be callable at $1,000. If the current interest rates are materially lower than the coupon rate on the bond (say current rates are 3 percent and the bond has a 5 percent coupon) there's incentive for the issuer to call them to refinance at a lower interest rate. The bigger the spread between the coupon and the current interest rates, the more incentive to call. If the bond is callable and there's a reasonable possibility that could happen, you want to calculate the yield to the call date instead of the yield to the maturity date. The only difference in the computations is the call price and call date are substituted for maturity price and date.
Things are different if you're looking at a bond fund. You may only see the current yield. If the fund has substantial holdings of bonds purchased at a premium, the yield over a period of time may look attractive, but the net asset value (NAV) of the fund may be declining because the premium a buyer will pay for those bonds declines every year. There's a tradeoff between current yield and capital. Thus, unless you consider both the current yield and the change in NAV, you're not properly analyzing the fund.
Things can get worse if you add taxes to the analysis. You're paying taxes on the high current yield, but get no benefit for the drop in NAV until you sell the fund, and that could be some years down the road. Taxes aren't a consideration if the fund is in a qualified retirement plan (e.g., an IRA, 401(k), etc.). Remember, if you owned the bonds outright, the bond premium could be amortized each year.
The discussion above assumes that the bonds are taxable. Some of the information is the same for tax-exempt issues, but the tax consequences are different.
If you're investing in individual bonds, compare yields to maturity. And get complete information on the bond. Is it callable? When? Are there special provisions that can affect the value? If you're looking at a bond fund, check the prospectus carefully.
Copyright 2021 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 01/27/21