How to Buy Bonds: A Primer
By Greer Gibson Bacon, CFP®
Each day, bonds “reprice” themselves to reflect the going rate for bonds with similar terms. To be a successful bond buyer, you need to know key terms, like those highlighted below.
$25,000 PV Washington GO 5% 01/01/2019 NC
Aa1/AA/AA+ 106.948 YTM 1.05%
Par value (PV) is a bond’s face value. Bonds mature at par, but may not be issued or trade at par. Most bonds are denominated in $1,000 increments and trade in $5,000 multiples.
Bond descriptions never change. They identify the issuer, type of bond, coupon rate, maturity, and other features, like call features or insurance. In our example:
Washington is issuer of a general obligation (GO), secured by its full taxing power. Different kinds of bonds provide different kinds of security.
The coupon rate is expressed as a percent per thousand. Annual interest for the Washington bond is $1,250 ($50 x 25) with $625 paid each January 1st and July 1st until maturity.
The maturity is the final maturity. Some bonds are “non-callable” (NC) and some are “callable” for early redemption if certain conditions are met. When bonds are called, it favors the issuer, not you.
Bond prices are expressed as a percent of par. A bond trading at 100 is a “par bond”. One trading at more than 100 is a “premium bond”, like our example. One trading at less than 100 is a “discount bond”. Fair market value equals a bond’s par value times its price ($25,000 x 106.948% = $26,737).
Some bonds have credit ratings. Those rated BBB or higher are “investment grade”. And, those rated BB or less are “speculative grade”, often called “junk” or “high yield” bonds. Some bonds are non-rated for various reasons. Learn more about credit ratings at www.sec.gov/investor/alerts/ib_creditratings.pdf.
All bonds have three yields. They include coupon rate, current yield and yield-to-maturity (YTM).
Current yield equals a bond’s coupon rate divided by its price. So, the Washington bond has a current yield of 4.67% ($50 ÷ $1,069.48). While the coupon rate is fixed, the current yield will vary based on the price of the bond.
YTM allows bond buyers to compare total return for bonds with similar but different descriptions. It takes into account each bond’s annual income plus the capital gain or loss (if any) realized at maturity, as well as its average cost. Like annual percentage yield (APY) for bank deposits or annual percentage rate (APR) for bank loans, YTM is the bottom line when you buy a bond. An exception applies to premium bonds that are callable where “yield-to-worst” (sometimes called, “yield-to-call”) applies instead.
When you buy a par bond, all yields will be the same. If you buy a premium bond, the coupon rate will be highest, followed by current yield then, yield-to-maturity. The opposite is true if you buy a discount bond. In terms of strategy, you might favor one or the other depending on whether rates are rising or falling.
Next up … How to Buy Bonds: When Rates are Rising
This article first appeared in the April 2017 Spokane County Medical Society Magazine. The information referenced in the article is current as of date of publication.