The Federal Reserve, commensurate 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. bonds to invest in As a result, 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 rather than its yield.
Bonds are normally issued in $1,000 face value increments. A relationship selling at below face value is reported to be selling at a "discount" ;.A relationship selling at its face value is reported to be selling at "par", and a bond selling for more than its face value is reported to be selling at a "premium" ;.Do not confuse these terms (discount, par, premium) with quantities of quality or value. A relationship selling at a premium does not necessarily make it better or for example more costly on a family member basis than the usual bond selling at par or perhaps a discount. Those terms are merely used to spell it out the bonds current price in accordance with its face value. So, if the dollar price of a bond 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 under consideration the purchase price, the maturity, and the coupon rate. Yield is an extremely important concept in bond investing that is typically overlooked by retail investors, who make value judgments by solely emphasizing the dollar price. Yield is an essential tool to gauge the return of just 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 one's return on your investment. Professional dealers and traders, when buying and selling bonds together, usually quote prices in yields not dollars; yield provides you with an instantaneous research the relative value in comparison to other bonds. When considering 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, often times, you can find value by comparing.
- When evaluating various maturities of exactly the same bond, look at the incremental yield (the spread) you'd be receiving by buying the longer maturity and ensure you feel it's worth the excess risk. Yields are quoted in basis points: 1 basis point is 1/100th of just one percent; 100 basis points is corresponding to 1%. As an example, 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 may not be worth the excess risk.
- Higher rated bonds will often offer a lower yield, other activities being equal. If you are evaluating a lowered rated bond, make sure the excess yield you'd get (the spread) with the reduced rated bond is worth the excess risk.
- Don't get caught up in a certain maturity date. Because of the way bonds are traded, it's very possible to get a bond with a shorter maturity that provides better value, other activities being equal.
- In this interest rate environment, consider buying higher coupon bonds (Premiums) which are generally more defensive should interest rates rise prior to when anticipated. But keep in mind when interest rates remain as is or go lower for a longer time period, bonds with call features might be redeemed prior to when what you had anticipated.
