Understanding the Shrouded World of the Bond Market. Part 2 of 2

What is the “yield-to-maturity” calculation and why is it important?
What happens in the bond market when interest rates increase?
What happens when interest rates decline?
What is the effect of premiums and discounts on bond yields and taxes?
What is a “yield–to–maturity” calculation and why is it important?

 

OOn March 27, Timothy Logan, President of Logan Wealth Management, hosted a webinar covering the fundamentals of the bond market. This presentation was entitled: Understanding the Shrouded World of the Bond Market. A Video of this webinar can be found here – LWM Webinar – Introduction to Bond Markets

The yield-to-maturity calculation measures the total return on an investment, not just the interest payment received. As bonds trade in a marketplace, the purchase /sale price is not always the same as its maturity value. Therefore, the total return earned (yield-to-maturity) reflects the difference between the transaction price and the maturity value, plus the annual interest rate earned.

To understand how this works, consider the following example: You purchase a $1,000 bond trading at its maturity value (referred to as par). The coupon rate is 3%, with a five-year maturity. This means you can expect to see a total return of $150 in interest, or $30 annually over 5 years.

What happens when interest rates increase?
If interest rates increase over the next year and comparable bonds offer interest payments of 5%, the market price for your bond will decline to $929.00.
The coupon rate will remain at 3%, but the total return will amount to $30 over each of the four years, plus $71, or the difference between the reduced purchase price of the bond and its par value at maturity.
In this scenario, a new purchaser will see a total return (or yield-to-maturity) of $191, or a 5% annualized return over four years.
As the original purchaser, assuming you continue to hold the bond, you still receive $150 over the lifetime of the investment, but in the short term, your statement will indicate a $70 decline in the bond price, before regressing back towards the maturity value over time.

What happens when interest rates decline?
If interest rates decrease one year later and comparable bonds offer interest payments of 2%, then the market price for your bond will increase to $1,038.00.
As with the previous example, the coupon rate remains at 3% and the total return will amount to $30 over each of the four years, minus $38, or the difference between the new purchase price and the par value of the bond at maturity.
In this scenario, a new purchaser will see a total return of $82, or a 2% annualized return over four years. (Again, this is the yield–to–maturity calculation.)
As the original purchaser, you receive $150 in interest over the lifetime of the investment, but your statement will indicate an increase in the bond price, realized only if you sell the bond prior to maturity. Upon maturity you will receive the $1,000 maturity value.

Additional Thoughts on Bond Pricing
Longer term bonds and bonds with lower coupons tend to have greater sensitivity to changes in interest rates, experiencing lower prices when interest rates increase and higher prices when interest rates decline.

What are the effects of premiums and discounts on bond yields and taxes?
For taxable accounts, we need to consider the effects of premiums and discounts. It is important to remember that the goal is not to trade income taxable as interest for income taxable as a capital loss.
Consider this example. Compare a bond trading at $100 with a 5% coupon and one trading at $120 with a 9% coupon. Over five years, the total cashflow earned will be equal. In the first instance, $5 over 5 years generates $25. In the second, $9 over 5 years minus the $20 premium also generates $25. But while the total cashflow is the same, the tax impact is not.
The 5% bond will receive $25 in interest over five years, while the 9% bond will receive $45. The capital gain on the 5% coupon will be calculated as zero, while the 9% bond will list a $20 capital loss, which can be used to offset capital gains. Recall, only 50% of a capital gain is taxable. Since tax rates are the same for both these investments, the taxes paid on the 5% investment will be less than those paid on the 9% one.

 

Conclusions
There are two key takeaways for this presentation:

● there is a difference between the coupon rate and the yield-to-maturity calculation;

● accept that pricing for the various moving parts is more complicated than it is for equities and requires thorough analysis.

 

Disclaimer: Please note that the information presented here is intended as general information only. It reflects the thoughts and opinions of Logan Wealth Management and should not be construed as investment advice. Please consult your adviser to determine whether this information is applicable to your personal situation.