The Federal Reserve, in keeping 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. As such, most bonds are now trading at what is referred to as 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 bond selling at below face value is said to be selling at a "discount" ;.A bond selling at its face value is said to be selling at "par", and a connection selling for a lot more than its face value is said to be selling at a "premium" ;.Do not confuse these terms (discount, par, premium) with examples of quality or value. A bond selling at a premium does definitely not ensure it is better or for example more costly on a relative basis than a bond selling at par or even a discount. Those terms are just used to spell it out the bonds current price relative to its face value. So, if the dollar price of a connection really doesn't express its' relative value, how do an investor compare bonds? That answer may lie in the bond's yield.
Yield takes into account the purchase price, 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 focusing on the dollar price. Yield is an important tool to assess the return of 1 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 on 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 a sudden check out the relative value compared to other bonds. When looking at yields, below are a few useful tips to find value:
- Compare the yield of the bond you're considering to other similar investments. Bonds are not as liquid as stocks and, many times, you will find value by comparing.
- When evaluating various maturities of the exact same bond, go through the incremental yield (the spread) you would be receiving by purchasing the longer maturity and be sure you feel it's worth the additional risk. Yields are quoted in basis points: 1 basis point is 1/100th of 1 percent; 100 basis points is equal to 1%. For instance, if you're 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 additional risk.
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- Higher rated bonds will most likely offer a lower yield, other items being equal. If you're evaluating a lower rated bond, make sure the additional yield you would get (the spread) with the lower rated bond may be worth the additional risk.
- Don't get swept up in a particular maturity date. Because of the way bonds are traded, it's very possible to obtain a bond with a shorter maturity that gives less expensive, other items being equal.
- In this interest rate environment, consider purchasing higher coupon bonds (Premiums) which are often more defensive should interest rates rise prior to when anticipated. But remember when interest rates remain as is or go lower for a lengthier time frame, bonds with call features may be redeemed prior to when what you had anticipated.
