Saving Bonds - Yield
The
term that you will come across most often when researching saving bonds (
and indeed any other type of bond) is yield. Now there are in fact three
different kinds of yield that we can measure, or which indicate the overall
performance of the bond. In simple terms all that the yield means is how
much you are going to get back on your initial investment. So the higher the
number the better your return and the more money you will have made on your
original capital invested in the bond. Understanding the yield or return is
one of the most confusing aspects of investing in bonds, but it is extremely
important so that you are able to understand the performance of the
bond and it's daily price fluctuations. Some bonds are not traded on the
markets, but of course many others are, and investors are often surprised
that the prices move up and down on a daily basis! The three most common
terms are, nominal yield, current yield, and yield to maturity, so let's
look at each of these terms in turn. You will also come across the yield
curve, which I will also try to explain.
Saving Bonds - Nominal Yield
The nominal yield is nothing more that the coupon rate, or the interest rate on the bond, and is not a every helpful measure ( I'm not entirely sure why it is used, unless it is just to confuse us mere mortals!!) So in simple terms and using US dollars, if we have a bond of $1,000 which is paying a 5% fixed interest rate, then over the year we would receive $50 so the return on the bond is 50/1000 , which is 5%. So the nominal yield is quoted as 5%!!
Saving Bonds - Current Yield
Because many bonds are traded in the open market, we need to have a measure of how the bond is performing against the original par value so that we can see how our original investment is performing - in other words are we better off than when we started, or worse off! An important measure as I'm sure you would agree. The formula is very simple as shown below :
CURRENT YIELD = COUPON AMOUNT /PRICE
So if we take the above example of $1000 with a 5% coupon or interest rate, then the current yield is 5% since $50 ( coupon amount)/$1,000 ( price) = 5%. However, supposing the price of the bond drops to $800 then the coupon current yield is still $50 ( coupon amount)/$800 ( the new price) = 6.25%. So as the price of our bond has fallen, then the current yield has increased from 5% to 6.25%. Suppose the bonds price had increased to $1200 then the current yield would fall to $50 (coupon amount)/$1200 ( the new price) = 4.16%.
Naturally if the bond price is the par value, then the current yield = the nominal yield as we saw in the first example. Once a bond has been issued and it's trading in the bond market, all of its future payouts are determined, and the only thing that varies is its asking price.
Saving Bonds - Yield To Maturity ( YTM)
When bond traders and brokers talk about yield, they are almost always referring to the YTM or yield to maturity. This is the most useful calculation as it considers the current market price, the coupon rate, the time to maturity, and assumes that interest payments are re-invested at the bonds coupon rate. It is quite a complicated calculation and is generally done with a computer programme. Now the formula to calculate YTM is as follows :
c(1 + r)-1 + c(1 + r)-2 + . . . + c(1 + r)-n + B(1 + r)-n = P
Fairly meaningless I know, unless you happen to be a maths graduate, and it is not necessary that you remember it, or even know it exists. I only include it here for those of you who may like to calculate the figures manually, where
c = annual coupon payment (in dollars, not a percent)
n = number of years to maturity
B = par value
P = purchase price
Now it is relatively straightforward to input some numbers and solve the equation in order to calculate r, the unknown. However, if you prefer to calculate it the easy way, here is a link to an online calculator saving bonds calculator - this will pop up in a separate window for you to enter the numbers - a little easier than the above, but at least you have both methods to try.
Saving Bonds - Yield Curve
The final term you will come across very often is yield curve. The yield curve describes the relationship between the interest rates and the maturity dates. Typically the yield curve is upward sloping asymptomatically suggesting that higher yields are offered to bonds with longer maturities. This is referred to as the 'normal' yield curve. However yield curves can also be inverted or humped in shape. Now you might ask why we bother analysing these graphs of yield at all - a fair question - In simple terms the yield curve serves as an important benchmark as it used to set yields in other debt markets such as corporate debt, bank loans, international bonds, and even the mortgage markets. The shape of the yield curve is closely monitored by the bond community as it helps anticipate future interest rate changes. There are four main variations of the yield curve: normal, humped, inverted, and flat.
As
the name suggests, the “normal yield curve” represents the typical yield to
bond term relationship. The upward sloping curve generally indicates periods
of economic prosperity and suggests that long term rates are higher than
short term rates. This structure implies that a bond holder will be
compensated for the additional risk of holding a bond for a longer period of
time. Additionally, the “steepness” of this curve can be a function of
strong economic prospects. Higher growth rates in the economy will lead to
higher inflation levels in the future and thus higher interest rates. An
example is shown on the left which is typical of the saving bonds yield.
Now the analysis of yield curves is a science in itself and there are many books and theoretical studies devoted to comparing one with another. This single topic is more debated and discussed than any other in the bond market and further analysis is beyond the scope of this site. I have tried to give you a little background to the saving bonds market where we are principally looking at low risk government backed saving bonds - but I hope that the above has given you a little background to the wider bond market, so that should you feel that a higher risk bond is more suitable for you, then at least you will understand some of the basic terms and terminology.
OK, I think that's about enough on yield! Now let's start to look at the bonds available in each country, starting with the saving bonds for the US market.