Understanding Bond Valuation and Yields
Bonds are fixed-income securities where investors loan money to governments or corporations in exchange for regular interest payments and principal repayment at maturity. Bond prices and yields have an inverse relationship: when interest rates rise, existing bond prices fall, and vice versa. Understanding this relationship is crucial for bond investors.
The bond's coupon rate represents the annual interest payment as a percentage of face value. A $1,000 bond with a 5% coupon pays $50 annually, typically in two semi-annual payments of $25. However, bonds rarely trade at exactly face value. When bonds trade below face value (discount), yield-to-maturity exceeds the coupon rate. When bonds trade above face value (premium), yield-to-maturity is lower than the coupon rate.
Yield-to-maturity (YTM) is the total return anticipated if a bond is held until maturity, including coupon payments and any gain or loss from purchase price. YTM assumes all coupon payments are reinvested at the same rate. For example, a bond purchased at $950 with a 5% coupon and 10 years to maturity has a higher YTM than 5% because you'll also gain $50 when it matures at $1,000.
Current yield provides a simpler measure: annual coupon payment divided by current market price. For a bond with a $50 annual coupon trading at $960, current yield is 5.21% ($50 ÷ $960). Current yield doesn't account for capital gains/losses at maturity or time value of money, making it less comprehensive than YTM but easier to calculate.
Bond duration measures price sensitivity to interest rate changes. A duration of 7 means a 1% interest rate increase causes approximately a 7% price decrease. Longer-term bonds have higher duration and greater price volatility. Conservative investors seeking stability prefer shorter-duration bonds, while those seeking higher returns may accept duration risk.