XTB CEO Richard Murphy explains the basics of bonds
Bonds are very basic
Bonds are very basic. You buy the bond and receive regular interest payments throughout the life of the bond. At maturity you receive a known amount – face value of the bond. How bonds perform in the market is reflective of the stability they offer.
Bonds provide greater predictability
This is particularly clear when comparing the performance of bonds versus equity. Because bonds provide a predetermined income and known outcome, their performance in the market is very stable compared to equity (shares).
Bonds help investors to sleep at night
Key terms and percentages
When looking at bonds one is confronted with different terms and percentages. Coupon rate, yield to maturity and running yield are all terms one associates with bonds. What do they mean and how do they affect the performance of a bond? Let’s look at an example:
If you buy a bond with a coupon of 7.75%, you will receive $7.75 a year. However in this current low interest rate environment, a bond with a coupon of 7.75% will have gone up in price. For our example we will assume the price has gone up to $117.15.
To calculate the running yield, the coupon is divided by the price of the bond, in this case 7.75%/117.15=6.61%. However, this equation ignores the fact that the bond is going to mature at the face value of $100. That is why the most important measure of a bond is yield to maturity.
Yield to Maturity
The yield to maturity does take into account the $7.75 per year of income but it also takes into account that the price of the bond is going to move down to the face value of the bond at maturity ($100). It is important to remember that you are buying an investment to hold to maturity, therefore focus should be on the yield to maturity not the coupon or running yield.
Read more about how to measure the performance of a bond.