Market Beat: Learning the basics of bonds
Fixed income investors today have had a difficult time finding yield with the record low interest rates we’ve seen.
Bond investors can choose between using mutual funds or can purchase the individual bonds themselves, depending on what is more suitable for their own unique situation.
If you are shopping for bonds, there is some basic terminology that you’ll need to understand to determine what is best for you to purchase.
Yield to maturity, or YTM, is the total return that you’ll receive if you hold your bond until maturity and the issuer does not default.
The coupon rate is the interest rate that the bond pays. There is a difference between YTM and coupon rate. If the bond you’re evaluating is trading on the secondary market, it may be trading at either a premium or a discount to its par value.
If it’s trading at a premium, the YTM will be less than the coupon rate, and if it’s trading at a discount, the YTM will be greater than the coupon rate.
Some bonds are callable, which means that the issuer has a right to buy your bond back from you prior to the maturity date. If the bond is callable, you can also calculate the yield to call, or YTC.
For example, you could purchase a 20-year bond that has a YTM of 4.5 percent, but it could be callable in five years, and the YTC might only be 1 percent.
Bonds can have multiple call dates or also be continuously callable. If there are multiple call dates, then you can calculate what the yield is for the worst possible call date known as the YTW, or yield to worst call.
Another term to understand if you’re considering tax free bonds is the taxable equivalent yield, or TEY. Municipal bonds can be free of both federal and state income taxes depending on your state of residence and the state of issuance.
If you live in Nevada, with no state income tax, you can shop for municipal bonds from all 50 states. California residents that desire income that is free from both state and federal tax are limited to purchasing bonds issued by the state of California.
The TEY is calculated by taking your tax rate and dividing it by the tax free yield. For example, if you’re in the 35 percent tax bracket, the TEY on a 3 percent municipal bond would be 3 divided by 0.65 — so the yield would be 4.62 percent.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.