For the past couple of years, the U.S. has been dealing with high inflation issues. To combat this, the Federal Reserve (Fed) has been increasing interest rates. The thought is that higher interest rates make borrowing less appealing because it's more expensive. This chain reaction has a two-sided effect.
The negative is that it makes debt such as mortgages, credit cards, and loans more expensive. The positive is that fixed-income investments like bonds offer higher rates. As of October 2023, many bonds offer yields well over 5%, making them an intriguing option for investors looking for guaranteed returns with essentially no risk.
If you're interested in taking advantage of bonds' high interest rates, here are two metrics you should know beforehand to determine if it's the right move for you.
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How do bonds work?
When you buy a company's stock, you're purchasing ownership in that company. When you buy an entity's bonds -- whether corporations, governments, or municipals -- you're essentially loaning them money. Bonds represent debt of the issuer.
In return for buying the issuer's bonds, they agree to pay you regular interest payments, called coupons. Investors will receive coupon payments throughout the term of the bond and then receive the bond's par value at its maturity date, which can be anywhere from a few months to 30 years away.
Bonds are generally less risky than stocks because the issuer has an obligation to cover its debts before it rewards its shareholders. But that doesn't make them risk-free (although Treasury bonds are as close as it gets). The issuer could default, or interest rates could rise, making lower-yielding bonds less attractive.
That's why understanding key metrics like par value and yield to maturity is essential before making an investment decision.
What a bond's par value is
A bond's par value is the amount the issuer agrees to pay you back at the bond's maturity date. It's its face value.
The price of bonds varies, but it's important to note that the price you pay for a bond can differ from its par value. Depending on market conditions, bonds can trade at a premium (above par value) or a discount (below par value).
For example, a $1,000 bond can sell for $950 or $1,050, but either way, $1,000 is what the coupon rate will be calculated from and what you'll receive when the bond matures. If the coupon rate is 4%, you'll receive $40 in annual coupon payments.
How a bond's yield to maturity works
A bond's yield to maturity (YTM) is the total return you can expect by holding on to it until its maturity date. It's expressed as an annual percentage and includes the coupon payments you'll receive and the gains or losses you experience when the bond matures and the issuer pays back the par value.
The formula to calculate YTM is:
- is the annual coupon payment (in dollars)
- is the bond's par value
- is the purchase price of the bond
- is the number of years until maturity
If you'd rather not deal with the YTM formula (I don't blame you), plenty of free calculators available online will let you plug in the numbers and do the calculations for you.
Why is it important to know par value and yield to maturity?
There are a handful of metrics surrounding bonds, but these two are key because they give you a better idea of the bond's potential worth and the income you can expect.
To see YTM in action, let's imagine you pay $950 for a bond with a $1,000 par value that offers a 5% coupon rate and matures in 10 years. Over those 10 years, you'll receive $500 in coupon payments ($50 annually) and an extra $50 because you only paid $950 for the bond. That $550 total you received represents a YTM of 5.66%.
Once you know the YTM, you can decide if it's a worthwhile investment for you. If the YTM isn't high enough for the risk, you may decide against it, and vice versa.
Investors' financial goals and risk tolerance vary widely, so there's no one-answer-fits-all regarding who bonds make sense for. More than anything, it's about being as informed as possible.
