Bonds are a form of debt. Investors lend you money and you promise you are going to pay it back to them with some interest on top of it. That’s it. The issuer is the one who borrows money. You as an investor are lending money to the company. So, when Target is issuing $1 billion in bonds, they’re actually borrowing that money from the pool of investors.
There are a few main things one should be familiar with when talking about bonds:
- Face value
- Coupon rate
- Yield to maturity
Face value (Par value)
Face value refers to money that the issuer owes you at the end of the term. Let’s say you lend out $1,000 to Target. Target needs to pay you that $1,000 at the end of the term. Typically, all bonds are quoted with a $100 face value at issuance.
Maturity refers to the amount of time in the lending/borrowing period. Therefore, if Target said they would repay you in 5 years, that’s the maturity of the bond. Maturity date is a specific date in the future when the last payment is due.
Coupon refers to the quarterly, semi-annual or annual payment you get for lending the money. It is expressed in percentage terms and it is contractual (meaning it doesn’t change). The payment is calculated by multiplying your coupon rate with the face value of the bond.
If Target offered you a coupon of 7% paid annually, that means that every year for 5 years you would get $70 (7% x $1000) from Target.
Yield to maturity (YTM)
Think of YTM as the market rate of return. If the company is paying you the same rate as the market, then the bond is priced at par. If the company is paying a higher rate than the market, the bond is priced at a premium, and if the company is paying a lower rate than the market, the bond is priced as a discount. As a rule of thumb, if interest rates go up, then bond prices (yields) go down. If interest rates go down, then bond prices (yields) go up.
So, what happens if the company is paying you 7%, and the market rate is 5%. You’d be getting a great deal. Or if it’s the other way around, you’d be missing out on greater returns.
Since coupon payments can’t be changed (contractual agreement), the way to adjust for this is to change the price. If your coupon rate is greater than YTM, you need to pay more than par for the bond. This is called buying at the premium.
Paying $87 more up front will bring your rate of return down from 7% to 5%.
On the other hand, if your coupon rate is lower than YTM, then you will need to pay less than par for the bond. This is called buying at the discount.
Paying $78 less up front will boost your return from 7% to 9%.
In summary, this is how things work:
Understanding YTM is probably the toughest part in the beginning. It is easy to look at the summary above and say “I’ll just memorize this.” However, that’s the worst thing you can do. Instead, take time to fully understand why things move in a certain ways because that way, you’ll always know the right answer.