Interest rates have dropped and it has caused many investors to search for higher income producing investments and is leading many into more complex fixed income products. Not all that appears to be safe is, and those that have read about the credit issues plaguing Wall Street know all to well the negative ramifications misunderstood investments can have on one’s financial present and future.

But we can improve our situations, not by taking on more risk but perhaps understanding the risk in what we own and are contemplating investing in. I would like to go over two simple but yet important concepts in bond investing that many, even savvy stock buyers do not fully understand and therefore under appreciate their importance. It is a bond’s yield to call and yield to maturity. 

Lets start with a simple CD. (Certificate of Deposit) CD’s are time deposits and you agree to invest your money for a certain period of time at a certain interest rate and at the end of that period, at maturity, you receive your money back plus interest earned.

Bonds of all types are available and work in a similar way. You place your money with a government entity or company and receive interest for that period of time and at the end you receive your principal back. There are many types of risks associated with bond investing from credit risk to interest rate risk just to name two but I want to focus on just two parts of the decision on whether a bond is right for you, first Yield to Maturity.

Yield-To-Maturity

When you purchase a bond, the price you pay may be more or less than the maturity value. The values of bonds will fluctuate and on the date of purchase, it could be trading above the maturity or par value, which is called a premium bond, or below it which is called a discount bond. The premium or discount you pay effects the overall return on the investment.

If you paid $950 for a $1000 bond, you paid a discount and the appreciation from $950 to the maturity value of $1000 plus the interest earned needs to be taken into account when evaluating the overall return on the bond. You not only earned the interest, but made $50.

The same holds true for a premium bond. If you paid $1050 for a $1000 bond, you paid a premium. The difference between what you paid over the maturity value would need to be subtracted to find out your overall return. In this case you earned interest but lost $50 on the investment.

When evaluating a bond you may want to invest in, you do not need to figure all this out. Your advisor or company you deal with will be able to tell you the yield to maturity. If a discount bond had a yield to maturity of 6%, and a premium bond had a yield to maturity of 6.1%, all other factors remaining equal, then the premium bond would be a better buy. The total return was better even though I paid more for it.

So it’s not just the interest rate the bond pays, it is also the price you are able to purchase it at that makes a difference.

Yield to Call

The yield to call is determined in the same way as the yield to maturity except the call date is used instead of the maturity date. Most bonds today have call provision which means the issuing organization has the right to redeem, call away (give your money back) earlier than the stated maturity date. They will most likely do this if they can turn around and borrow at a lower rate than they are paying you. Just like you might refinance your home mortgage at a lower rate.

The effects of a discount or premium paid are magnified since the gain or loss, in this case of $50.00 is compressed over a shorter period. Making $50.00 over a shorter period of time is a good thing, losing the $50.00 premium over a shorter period of time is a bad thing and hurts your overall total return.

The interest rate you receive may increase the chances of a call. If a bond has a high interest rate and the current rates are much less, the bond has a greater risk of being called away and therefore a premium bond holds more risks under this environment.

Fortunately, the yield to call just like the yield to maturity is readily available to you from your advisor. When investing in bonds, the price you pay can have a dramatic effect on your return. The higher the yield to maturity on a premium bond does not equate to a better investment if the chances of a call are higher.

Knowledge is king in bond land, don’t be lead by the nose, know what you are buying and understand the risks first, reaching for a higher yield and ignoring the risks could result is a major loss of principal. On Wall Street, there is no free lunch.

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