Premium Bond Question
Hey all, I have a rather elementary question--I hope you understand and ask for your patience with my ignorance. I never really had a fundamental grasp of the concept of bonds, and had a question about an example I saw on Investopedia. The example was as follows: on Day 1, a bond has a par value of $1000 and a 10% coupon with a 1 year maturity, but on Day 2, it plummets and is now at a market price of $800. The yield (whatever that is) is calculated as 100/800 = 12.5%.
Here's what I don't get about this calculation. This is my line of thinking: say you buy the bond on Day 2. At the end of the year, your net worth is -$800 + $1100 = $300. The "profit" you earned consists of a) the $1000 face value you get paid, b) the $100 in coupons, c) minus the $800 you paid to get the bond on Day 2. Continuing my line of thinking, it makes sense to me that the yield should be 300/800 = 37.5%.
So my question is: when calculating yield, why would you not take into account the profit you pocket BESIDES the coupon payments?
You are looking at the bond as a total return instrument, where you factor in both the carry (yield) and your actual capital gain when you sell the bond. In this case, you are looking at the total return over that 1 year. Think about it if you are holding a stock. If I have 100 shares of GE at 20 a share and they pay a dividend of 1.00 a year my yield is 5%. We'll go one better, and say that GE will without a doubt end up at 23 dollars at the end of the year and you'll sell it. Then you'll have a capital gain, on the selling of the shares, of 300 dollars. Over the course of the year, you've now earned 100 dollars in dividends and 300 dollars in capital gains. So you now have a 20% return on your initial investment, 5% of it to dividends and 15% in capital gains. Note: this is really simplified.
You could theoretically sell that bond tomorrow at 850, and if it moves like that you probably should. Yield just represents the cash flows you are receiving while holding the asset which is entirely different from the actual gain on the underlying value of the asset once you sell it. You haven't sold the asset therefore you are just assuming a profit on an asset in the future. That is a really bad idea, for many different reasons outside of the difference between yield and capital gains.
I'm not going to go into the reasons that you wouldn't assume you get that bond back at par, I can ramble on some of them if you want, but I think the takeaway is to remember that yield simply represents the cash flows you are getting and doesn't include the future capital gain you may (or may not) realize.
Thanks a lot! It makes sense now. If you can, could you elaborate on one or two reasons why you can't assume you'll get the bond's face value back at maturity? I thought the whole point of bonds was that you receive interest as well as the principal at the end
So, I'm going to focus on two types of debt: Government and Corporate. For our purposes, Government contains all your municipal debt, agency debt and treasury debt. Largely, treasuries are seen as risk free and are used as a benchmark to measure how 'risky' an entity is. In the corporate world there are many different ways to look at the credit but generally you can look across the curve and see your investment grade, anything in the A category stuff, B category which is more speculative with different tiers and then C category which is Very speculative and anything there is nearing the , 'Look out below' category of default. If they hit default, they'll end up negotiating with creditors and you absolutely won't get back par. You'll be happy with cents on the dollar. Some funds will buy this type of stuff at like .10 cents hoping to get back .20 or .30 once the dust settles.
With that out of the way, the odds of your recovering 100 cents on the dollar at maturity largely move along those ratings scales. Investment grade stuff is generally reliable to get your money back and as such don't trade at a steep discount to par. B and C all have higher odds of not getting your money back and could trade at discounts and very substantial discounts as their credit worthiness falls off a cliff. In short, it's all about being able to gauge how likely the underlying entity will be able to fulfill their pledge to you of paying your money back at the end of the term.
I know this is a long winded answer regarding why you may not get your principal back, but it's important to understand that everything is based around the notion that not all promises made are kept. So when you evaluate whether you want to buy a bond or not you need to do a lot of work on the underlying company and their financial situation. It's said that bond guys tend to be more depressing and focus on the downside and that is largely true. When I buy a bond, I care more about whether you are going to fail and not how much you are going to succeed (at least in general). It's the same reason that people with low credit scores create higher yielding debt; their risk profile is higher and some percentage simply won't pay the money back. Same in the corporate world.
Government bonds, especially municipal debt, are slightly different because of the features they have and who issues them. When you are looking at buying municipal debt you have two major types: Revenue or General Obligation debt. GO debt usually cares taxing power which makes it much safer than revenue bonds. Then you have to be cognizant of exactly how much weight that taxing authority carries, whether it is full taxing authority or whether the tax base will even be there etc. Detroit is a great case study in what is going on in that market. Revenue bonds are simpler in that they are based on a project, lets say a toll bridge, where you need to make sure that the revenues from the toll bridge are enough to pay back the bonds. Normally it's taken care of in something like a coverage ratio of revenue/debt service or something of that nature. You can also have reserve funds which provide additional coverage and collateral against the revenue debt.
Agency and treasury debt I'll lump into one category because realistically agencies don't offer much of a spread anymore to treasuries and agency debt is shrinking anyway due to the wind downs in Fannie, Freddie etc. Obviously, these are the ones that you are most safe in assuming you will get your money back at par. Fun point, pull up some treasury prices. They are trading well above par, and some are even trading into negative yields where you are paying so much of a premium that you will lose money even though they are paying back par at maturity.
There are a million different features of bonds that make them far more interesting than things that you simply buy at 99 and hold for a year to receive par + the interest you got over time. Roll down, convertible debt, callable bonds the list goes on.
Well that would've been a bad assumption if you bought Bear Stearns bonds in 2007 that were due to mature in 2020. See why you can't assume that? Ever heard of distressed debt?
You're experiencing the difference between the different "flavors" of yield. The Investopedia calculation is what's known as the "running" or "simple yield". It's not a particularly useful concept, as you have discovered, so instead people use the "redemption" or "yield to maturity". I think this is what the previous poster has also explained.
Bond premium/discount question (Originally Posted: 02/07/2015)
I think I have a handle on how to handle amortization of bond premia and discounts from an issuer's perspective (create a liability/contra-liability, interest expense reduced/increased to match payables until the account runs to 0).
Do we have to make similar adjustments if the company buys bonds instead of issues them at the discount/premium?
bump
bump. would appreciate any help on the accounting
Your yield is actually higher cause you held the instrument for 359 days (usually 360 days in a year for bonds, for simplicity). So you got that much profit in slightly less than one year. You are now a rockstar.
The funny thing is that you would have thought that there's no way that, in the actual industry, anyone would use this funny concept of "running" yield, given that it often has very little to do with the economics of the bond transaction. However, the whole massive friggin' JGB mkt actually uses "simple" yield on a day-to-day basis. Go figure...
But it's these "simple" or "running" yields that get reported as just "yields" in newspaper headlines, right?
For Japanese bonds, yes... For most other places, hell, no. To my knowledge, it's normally YTM.
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