Understanding Bonds and Other Fixed Income Securities

Todd Voit |

If an investor is looking at the bond market today, many bonds they observe will have higher coupon rates because most bonds were originally issued at different dates in the past (refer to Figure 1).  As a result, the investor will have to pay a premium, a dollar amount greater than the $1,000 face value such that between the higher than current coupon rate and the higher price declining to maturity, all bonds of similar credit quality and with the same maturity will pay the same “yield-to-maturity”.  Again, whether a bond maturing in 1 year was a 5 year bond issued 4 years ago, a ten year bond originally issued 9 years ago or a 20 year bond issued 19 years ago, all three of them currently have 1 year to maturity. The yields for their given maturity (something referred to as yield-to-maturity) reflect the prevailing rates of bonds of similar maturities based on today’s interest rate levels. The bond’s price adjusts to equate these yields since they all mature in one year.

A more realistic example is shown in Figure 2 where the percentage of gain/loss is shown in the far right column.  These are not necessarily actual losses but instead reflect the decline in price to reflect the relationship mentioned above.  The Deluxe Corp. bond, purchased 11/01/2013 and maturing 10/01/2014, is a good example. Bonds purchased in the market last November did not offer a yield-to-maturity of 5.125% (as listed in the description of the bond) for the remaining 11 months to maturity.  Bonds with similar maturities were yielding 1.8% at that time. Figure 3 illustrates the initial purchase price to equate the 5.125% coupon with the $1,030 price paid to yield 1.8%.

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