Figuring Bond Yields

BONDS HAVE TWO yields: a current yield and a yield to maturity. Let's take them one at a time. When you're looking to buy a bond, it's very important not to confuse one with the other.

Current Yield

A bond's current yield is the annual return you get on your investment, regardless of its maturity.

But the current yield may not be the same as the bond's coupon rate. If you pay par for the bond, it will be. But remember, the price of a bond fluctuates every day in the market. So at times, it may trade at a premium above its par value and at other times, at a discount below its par value.

The price you pay to buy or sell a bond affects its current yield. For example, suppose you bought a 30-year bond with a par value of $1,000 back in the 1980s, with a coupon rate of 10%. But since then, interest rates have dropped considerably. So, you sell your bond and make a profit on your investment.

How much? That depends on how much interest rates have dropped since you bought your bond. But another investor would definitely be willing to pay you more than $1,000 for your old bond yielding 10% because newer bonds are only yielding, say, 5%.

Regardless of what you pay for a bond, the formula for calculating your current yield remains the same:

Annual Interest Payment / Bond Price = Current Yield

Yield to Maturity

This figure tells you how much you will earn from your investment if you hold a bond until it matures—or you sell it above or below its $1,000 par value.

You don't have to calculate a bond's yield to maturity yourself. Every brokerage house and bank that sells bonds has tables that have done the math for you.

Never buy a bond on the basis of its current yield alone. The bond's yield to maturity is the only figure that tells you how much the bond is worth to you, depending on what you pay for it.

If you buy a bond at par, your yield to maturity will be very close to its stated current yield and the same as its coupon rate. But zero-coupon bonds, you recall, don't pay any interest at all until the bond matures. At that point you get back your principal plus all the interest that has accrued over the life of the bond. So, zeros have no current yield, only a yield to maturity.

In the bond world, yield to maturity is the only way to compare bonds that are very different from one another. That's why yield to maturity is the figure bond experts use and you should, too.

What's Your Total Return?

One of the problems with fixed-income investments is that your total return from buying a bond doesn't just depend on its yield to maturity. It also depends on what you do with your interest payments, which are usually made semiannually.

Many people, of course, use this interest income to live on, often after they've retired. But a bond with a yield to maturity of 8% won't really give you a total return of 8% unless you can keep reinvesting your interest payments at that rate for the life of the bond. Whether or not you can do that, of course, is impossible to say when you buy the bond.

• **Strategic Response #1 to unpredictable bond returns.** Buy zero coupon bonds, which grow in value at a fixed rate for a specified period of time.

• **Strategic Response #2 to unpredictable bond returns.** Buy other original issue deep discount bonds, which are bonds that are issued at a discount to their par value and carry a low coupon rate.

Both these options will give you a pretty good idea of what your total return on your investment will be.

All this is a lot to take in at one time. But as we go along, these terms will come up over and over again. So, you may want to look back at these definitions often.