The Federal Reserve, consistent with its dual mandate of pursuing full employment and stable prices, has been conducting aggressive monetary policy driving interest rates to historically, low levels. This action by the Fed has triggered large gains in bond prices. invest bonds Therefore, most bonds are actually trading at what is called a "premium" ;.Premium bonds are misunderstood by the retail investor who typically focuses their attention primarily on the dollar price of the bond in place of its yield.
Bonds are normally issued in $1,000 face value increments. A connection selling at below face value is considered selling at a "discount" ;.A connection selling at its face value is considered selling at "par", and a relationship selling for a lot more than its face value is considered selling at a "premium" ;.Do not confuse these terms (discount, par, premium) with examples of quality or value. A connection selling at a premium does certainly not make it better or for example more costly on a family member basis than a bond selling at par or perhaps a discount. Those terms are only used to describe the bonds current price relative to its face value. So, if the dollar price of a relationship really doesn't express its' relative value, just how can an investor compare bonds? That answer may lie in the bond's yield.
Yield takes into account the cost, the maturity, and the coupon rate. Yield is an exceptionally important concept in bond investing that is typically overlooked by retail investors, who make value judgments by solely emphasizing the dollar price. Yield is a significant tool to assess the return of one bond against another [other things being equal, like credit ratings, call features, and/or the maturity date]. Essentially, "yield" could be the rate of your return in your investment. Professional dealers and traders, when buying and selling bonds to one another, usually quote prices in yields not dollars; yield provides you with an immediate look into the relative value in comparison to other bonds. When considering yields, here are a few useful tips to search for value:
- Compare the yield of the bond you're considering to other similar investments. Bonds are not as liquid as stocks and, often times, you can find value by comparing.
- When evaluating various maturities of the same bond, look at the incremental yield (the spread) you would be receiving by purchasing the longer maturity and be sure you feel it's worth the extra risk. Yields are quoted in basis points: 1 basis point is 1/100th of one percent; 100 basis points is corresponding to 1%. For instance, if you are comparing a 15 year bond with a 30 year bond, and the 30 year bond yields only 5 basis points more, that is probably not worth the extra risk.
- Higher rated bonds will often provide a lower yield, other activities being equal. If you should be evaluating a lesser rated bond, ensure the extra yield you would get (the spread) with the reduced rated bond may be worth the extra risk.
- Don't get swept up in a certain maturity date. As a result of way bonds are traded, it's very possible to get a bond with a shorter maturity that offers less expensive, other activities being equal.
- In this interest rate environment, consider purchasing higher coupon bonds (Premiums) which are generally more defensive should interest rates rise sooner than anticipated. But remember that when interest rates remain as is or go lower for a longer period of time, bonds with call features may be redeemed sooner than what you had anticipated.
