Question

a bond's face value is the same as its

a) risk rating

b) Principal

c) coupon value

d) yield

Answer 1

Bond Risk

The inverse relationship between price and yield is crucial to understanding value in bonds. Another key knows how much a bond’s price will move when interest rates change.

To estimate how sensitive a particular bond’s price is to interest rate movements, the bond market uses a measure known as duration. Duration is a weighted average of the present value of a bond’s cash flows, which include a series of regular coupon payments followed by a much larger payment at the end when the bond matures and the face value is repaid, as illustrated below.

Duration, like the maturity of the bond, is expressed in years, but as the illustration shows, it is typically less than the maturity. Duration will be affected by the size of the regular coupon payments and the bond’s face value. For a zero-coupon bond, maturity and duration are equal since there are no regular coupon payments and all cash flows occur at maturity. Because of this feature, zero-coupon bonds tend to provide the most price movement for a given change in interest rates, which can make zero-coupon bonds attractive to investors expecting a decline in rates.

Bond’s Face Value

Face value, also known as par value, is equal to a bond's price when it is first issued, but thereafter the price of the bond fluctuates in the market in accordance with changes in interest rates while the face value remains fixed.

The various terms surrounding bond prices and yields can be confusing to the average investor. A bond represents a loan made by investors to the entity issuing the bond, with the face value being the amount of principal the bond issuer borrows. The principal amount of the loan is paid back at some specified future date, and interest payments are made to the investor at regular, specified intervals during the term of the loan, typically every six months.

A bond is a fixed-rate security or investment vehicle. The interest rate paid to a bond investor or purchaser is a fixed, stated amount, but the bond's yield, which is the interest amount relative to the bond's current market price, fluctuates along with price. As the bond's price fluctuates, the price is described relative to the original par value, or face value; the bond is referred to as trading either at a premium, synonymous with above par value, or below par value, often referred to as a discount.

Three of the factors that influence a bond's current market price are the credit rating of the entity that issued the bond, the market demand for the bond and the time remaining until the bond's maturity date. The maturity date is an important factor because as the bond nears its maturity date, which is the date when the bondholder is paid the full face value of the bond, the bond price naturally tends to move closer to par value.

An interesting aspect of bond pricing and demand is revealed in the effects of reports issued by bond rating companies such as Moody's or Standard & Poor's. Lower ratings generally cause a bond's price to fall since it is not as attractive to buyers. But when the price falls, that action tends to increase the bond's appeal because lower priced bonds offer a higher yield.

Coupon Rate and bond’s price

All types of bonds pay an annual interest to the bondholder, and the amount of interest is known as the coupon rate. Unlike other financial products, the dollar amount (and not the percentage) is fixed over time. For example, a bond with a face value of $1000 and a 2% coupon rate pays $20 to the bondholder until its maturity. Even if the bond price rises or falls in value, the interest will remain $20 for the lifetime of the bond until the maturity date.

When the prevailing market interest rate is higher than the coupon rate of the bond, the price of the bond is likely to fall because investors would be reluctant to purchase the bond at face value now, while they could get a better rate of return elsewhere. Conversely, if prevailing interest rates fall below the coupon rate the bond is paying, then the bond increases in value (and price) because it is paying a higher return on investment than an investor could make by purchasing the same type of bond now, when the coupon rate would be lower, reflecting the overall decline in interest rates.

Why Coupon Rates Vary

When a company issues a bond in the open market for the first time, it bases the coupon rate at or near the prevailing interest rates to make it competitive. Also, if a company is rated “B” or below by any of the top rating agencies, it must offer its coupon rate at a price higher than the prevailing interest rate to compensate investors for assuming additional credit risk. In essence, the coupon rate is affected by the prevailing interest rates and the issuer’s creditworthiness.

The prevailing interest rate directly affects the coupon rate of a bond, as well as its market price. Interest rate refers to the Federal Funds Rate that is fixed by the Federal Open Market Committee (FOMC). The Fed charges this rate when making interbank funds transfers to other banks and the rate guides all other interest rates charged in the market, including the interest rates on bonds. The decision on whether or not to invest in a specific bond depends on the rate of return an investor can generate from other securities in the market. If the coupon rate is below the prevailing interest rate, investors will move to more attractive securities that pay a higher interest income. For example, if other securities are offering 7% and the bond is offering 5%, investors are likely to purchase the securities offering 7% or more to guarantee them a higher income in the future.

Investors also consider the level of risk that they have to assume in a specific security. For example, if an early-stage company or an existing company with high debt ratios issues a bond, investors will be reluctant to purchase the bond if the coupon rate does not compensate for the higher default risk. Purchasing such a high-risk bond does not guarantee that the issuer will repay the initial investment. Therefore, bonds with a higher level of default risk, also known as junk bonds, must offer a more attractive coupon rate that compensates for the additional risk.

Bonds issued by the United States government are considered free of default risk and are considered the safest investments. Bonds issued by any other entity apart from the U.S. government are rated by the big three rating agencies, which include Moody’s, S&P, and Fitch. Bonds that are rated “B” are considered “speculative grade,” and they carry a higher risk of default than investment grade bonds.

Bond Yield

Yield is a general term that relates to the return on the capital you invest in a bond. You hear the word “yield” often with respect to bond investing. There are, in fact, a number of types of yield. The terms are important to understand because they are used to compare one bond with another to find out which is the better investment.

Coupon yield is the annual interest rate established when the bond is issued. It’s the same as the coupon rate and is the amount of income you collect on a bond, expressed as a percentage of your original investment. If you buy a bond for $1,000 and receive $45 in annual interest payments, your coupon yield is 4.5 percent. This amount is figured as a percentage of the bond’s par value and will not change during the lifespan of the bond.

Current yield is the bond’s coupon yield divided by its market price. To calculate the current yield for a bond with a coupon yield of 4.5 percent trading at 103 ($1,030), divide 4.5 by 103 and multiply the total by 100. You get a current yield of 4.37 percent.

Say you check the bond’s price later and it’s trading at 101 ($1,010). The current yield has changed. Divide 4.5 by the new price, 101. Then multiply the total by 100. You get a new current yield of 4.46 percent.

Note: Price and yield are inversely related. As the price of a bond goes up, its yield goes down, and vice versa.

If you buy a new bond at par and hold it to maturity, your current yield when the bond matures will be the same as the coupon yield.

Yield-to-Maturity (YTM) is the rate of return you receive if you hold a bond to maturity and reinvest all the interest payments at the YTM rate. It is calculated by taking into account the total amount of interest you will receive over time, your purchase price (the amount of capital you invested), the face amount (or amount you will be paid when the issuer redeems the bond), the time between interest payments and the time remaining until the bond matures.

Yield-to-Call (YTC) is figured the same way as YTM, except instead of plugging in the number of months until a bond matures, you use a call date and the bond’s call price. This calculation takes into account the impact on a bond’s yield if it is called prior to maturity and should be performed using the first date on which the issuer could call the bond.

Yield-to-Worst (YTW) is the lower of a bond’s YTM and YTC. If you want to know the most conservative potential return a bond can give you – and you should know it for every callable security – then perform this comparison.

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