Bonds help add diversity to your portfolio and control risk. But they can be complicated. We can help you understand the basics and make bonds work for you.
You can buy a bond at either a discount or premium to its face value. A "discount bond" sells for less than its face value, or par, which is the price the issuing company or governmental agency will ultimately pay when it redeems the bond. A premium bond's selling price exceeds its par.
Sometimes bonds are issued at a discount in an effort to attract buyers. But most discounts develop mainly as a result of changes in interest rates. To understand how that happens, start with a hypothetical 30-year corporate bond with a $1,000 face value issued 20 years ago with a 5% coupon interest rate. That means it has been paying $50 a year (5% of $1,000) for the past 20 years and is now ten years away from maturity.
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You wouldn't give the owner $1,000 for that bond today because rates have risen since then, and you expect to earn more than $50 for each $1,000 you invest in bonds now. At what price would that 5% bond become a good buy? Finding out takes some math, but not much.
First, compare the current yield. The current yield is the annual interest payment divided by the current price. To put it another way, the current price is the annual payment divided by the current yield. Let's assume that other bonds you could buy are yielding 6.9%. The bond you're considering buying must match that or you should pass it up. What price for the $1,000 bond would make it yield 6.9% to the buyer? Here's the math: Price = 50/0.069 = $725 (rounded off). So $725 would be a fair price for this bond.
Next, find the yield to maturity. The 5% bond pays $50 a year and will be redeemed in ten years at its par value of $1,000, which is $275 more than the current price suggested by current interest rates. You won't realize the $275 for ten years, but for mathematical convenience let's say you receive the discount as equal installments of $28 for each of the ten years. The percentage figure that tells you how much you are earning from interest payments plus the annual payout of a tenth of the discount is the yield to maturity.
Unfortunately, you don't simply add and then divide. Bond dealers use bond tables and programmed calculators to compute yields to maturity, and some handheld financial calculators can do it. But you can approximate the yield to maturity with the following shortcut formula: annual interest + anually accumulated discount/ average of par value and current price x 100
For the bond in the example: 50 + 28 = 78/860 = .09069 x 100 = 9.06% = 9.1%
The same formula can be used for bonds for which you pay a premium. In those cases you would subtract the annually accumulated premium from the annual interest payment.
Don't worry about following this exercise too closely. It's presented not as a mathematical model for you to use, but as an example of the kinds of considerations that affect the value of a bond you might buy or sell at a discount.
Other Things to Consider
Stay up to date on the credit rating. A bond's quality rating may be revised after it is issued because of a change in the issuer's financial health. Many bonds have been on the market a long time, so it's important to check current ratings.
Be sure there's an easy exit. Although you may buy a bond firmly intending to hold it to maturity, it usually doesn't make sense to freeze yourself into an investment. Ordinary investors should restrict themselves to investment-grade bonds that can be priced and sold easily to other investors.
Watch your maturities. Often you can select bonds that will mature exactly when you need large sums -- say, for college expenses or, at retirement, for reinvestment in bonds with high current yields to supplement your pension income. Also, remember that the further away a bond's maturity date, the riskier it is as an investment.