Clearing Up Commonly Confusing Concepts Of Fixed Income
Now that you’re familiar with the yield curve and different types of fixed income, let’s clarify some key concepts and terms that can sometimes cause confusion.
What’s The Difference Between Yield And Interest Rates?
In general, the usage of the terms yield and interest rates varies depending on the type of financial instrument being discussed. Investors of stocks or bonds often use the word yield to express the annual return, dividend or interest received on an investment. A simple bond yield formula is: yield = coupon amount / price.1 In other words, a bond with a 5 percent coupon (the annual interest rate the issuer pays a lender to borrow money) and a par value of $1000 (the bond’s face value) that is priced at $800 would have a yield of 6.25 percent ((5% * $1000) / $800).
Yield to maturity (YTM) is an advanced calculation for determining the total return of holding a bond to maturity. It incorporates par value, coupon, current market price, and time to maturity assuming all coupon payments get reinvested at the same rate as the present yield. It is useful when comparing bonds with different coupons and maturities.
Interest rates on the other hand are more commonly used to describe the annual percentage rate (APR) that a lender charges a borrower for a loan. When looking at loans and interest bearing investments, another common term that appears with APR is annual percentage yield (APY). The principle difference is APR does not include intra-year compounding, but APY does.
Why Do Yields Rise When Bond Prices Fall?
Although the Federal Reserve announced it was not raising the Fed Funds rate on September 17th, expectations are for an interest rate hike within the next 12 months.4 With a rate hike on the horizon, it’s helpful to understand how that could affect the bond market.
In a rising interest rate environment, existing bond prices tend to fall as investors sell lower yielding bonds in favor of newly issued higher yielding bonds.
Let’s say you bought a bond with a par value of $100 and a $5 annual coupon; the yield is 5 percent. In a rising interest rate environment, a new similar type of bond might offer a $6 annual coupon instead. As a result, your old bond might fall from $100 all the way down to $84.5 in order to yield the same 6 percent ($5 / $84.5 = 6 percent).
The opposite occurs in falling interest rate environments: existing bond prices rise as investors look to buy existing bonds with higher yields. The new bonds issued have lower coupons because they don’t have to pay as much in a lower interest rate environment. As existing bonds are bid up, yields fall. For example, your old bond with a $5 annual coupon gets bid up to $150 from $100. The yield is now $5 / $150 = 3.33 percent. The market will eventually decide the price of the bond and yield.
Source: Legal & General
Are Maturity And Duration The Same Thing?
Although they may sound similar, maturity and duration have different meanings. Maturity describes the number of years remaining until a bond is due to repay its principal back to investors.
Duration, on the other hand, measures how sensitive the price of a bond is compared to a change in interest rates. Increases in interest rates decrease the prices of existing bonds and vise versa.
Some of the inputs used to determine a bond’s duration include its maturity, coupon, yield and call features. The three most commonly used methods advanced investors use to measure duration are Macaulay, modified and effective.5
Duration is measured in years and is helpful to understand if you are considering selling a bond prior to maturity because your liquidation price will be impacted by any interest rate changes.
Bonds with longer durations tend to have higher yields and are more sensitive to changes in interest rates than those with shorter durations. If you anticipate interest rates to rise, purchasing bonds with shorter durations could be favorable.
Source: Duke University
What Are The Differences Between Par Value, Face Value, And Market Price?
Par value and face value are interchangeable terms used to represent the dollar value of a security stated by the issuer. In other words, it means how much a bond says it is worth.
It helps to understand that par value is the amount the issuer pays back to the holder at maturity if the bond doesn’t default regardless of how it traded during its lifecycle. Par value for bonds is typically $1,000 or $100.
When you actually purchase a bond, how much you pay for it on the open market is known as the market price. The market price could equal the par value, but this typically doesn’t happen because market prices fluctuate.
There are many different factors that affect if a bond’s market price is trading at a premium (above par) or at a discount (below par). As you already know, interest rate levels can impact bond prices. The issuer’s credit status can also affect how a bond trades compared to par.
Is It Possible To Gain Fixed Income Exposure Without Buying Bonds?
Yes! Fortunately if you are interested in diversifying your portfolio into fixed income and need help getting started, motifs can be a great option. Take a look at our catalog of fixed-income themed motifs, which include ETFs covering munis, Treasuries, corporate bonds and more. Ready to get started? Open a free Motif Investing account today.
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