Investing

How Bonds Work (VIDEO)

  • 01.MAY.2018
  • Richard Murphy,  XTB

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

Bonds vs shares in 2017 - stability of bonds helps investors sleep better 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:

Coupon Rate

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.

Table of corporate bond measures

Running Yield

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.

View this video on YouTube

Read more about how to measure the performance of a bond.

Events

  • 29May 2018

    YTMDOW: DOWNER GROUP 5.75% 29 NOV 2018

    This is the coupon date

  • 03Jun 2018

    YTMANZ: ANZ 3.25% 03 JUN 2020

    This is the coupon date

View Calendar
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