Bond Investments. Here are the most important bond investing tips and strategies.
Investing in Bonds
Investing in Bonds: Accrued Interest
Accrued interest – this is very important in bond investing, as it affects the way bond prices are expressed. This is the interest earned on a bond since the last interest payment date of the bond. This amount is usually paid by the buyer to the seller as compensation for the loss of this interest when the next payment is made to the new bond owner.
Accrued Interest Formula
Accrued Interest in Money Terms = Coupon x (Trade settlement Date – Last Interest payment date)/365 x Face Value of Bond
Accrued Interest in Price Terms = Coupon x (Trade settlement date – Last Interest payment date)/365
Factors that affect accrued interest
- Coupon – this is the fixed-percentage interest rate that is payable on the face value of the bond (also known as the par or the nominal value)
- Trade date – Usually a few days after the transaction of your order
- Last interest payment date
- Face value of bond – The face value of a bond and the price you pay for it will usually differ.
Accrued interest is a figure that helps ensure that fair payments are made – the owner earns full interest on the total amount of time for which he has held the bond.
Investing in Bonds: Running Yield
This is the easiest way to calculate the return on a bond investment. The running yield is also known as the simple yield or the current yield. Other more sophisticated ways of calculating yield on investment bonds include adjusted current yield and redemption yield. The running yield expresses the basic relation between a bond’s fixed interest rate (also known as its coupon) and its price.
The adjusted current yield, on the other hand, adds the annualized change between the current price and the redemption price in its calculations.
Factors that affect running yield
- Coupon – the stated interest rate on the bond. ‘6% Treasury stock 2010’ means that the coupon is 6%.
- Clean price – this is the current price of the bond, and excludes accrued interest
Running Yield Formula
Running Yield = (Coupon / ‘Clean’ Price) x 100)
Adjusted Current Yield = Running Yield + (100 – ‘Clean’ price)/Years to Maturity)
Advantages of Running Yield
This is the easiest to calculate, and shows the most important factor in deciding on bond investments: the inverse relationship between a bond’s yield and its price.
Investing in Bonds: Redemption Yield
Sometimes called the Yield to Maturity, this is the most accurate way to compare different bonds, as it considers more factors than that used to calculate running yield. These factors are also those you must consider in investing in bonds: the length of the bond’s remaining life, the capital gain or loss, the income from reinvesting coupons received during the bond’s life
The three most important components of the redemption yield are the following: the running yield, the compound interest if all interest payments were reinvested, the annual rate of capital gain or loss if bonds were held to maturity.
Redemption Yield = Running Yield + ‘Interest-on-Interest’ + Annualized gain or loss on maturity
Factors that affect Redemption Yield
- Coupon – Stated interest
- Current Price of the bond
- Accrued interest
- Maturity date and par value
Importance of redemption yield
Redemption yields on bond investments indicate several important conditions:
- Health – bonds that are about to run to maturity will normally have lower yields than those with later redemption dates, as money is valued higher the earlier it will be available. The yield curve expresses the relationship between bond yield and redemption dates.
- Risk-free rate of return – The yield to maturity value is a good indicator of what the market sees is the annual risk-free rate of return for a certain period of time.
- Measure of credit quality – US Treasury bills are usually the benchmark against which other bonds are measured. The difference between yields of bond investments of the same maturity is represented by the ‘spread’.