Most investors make bond purchase decisions based primarily on interest rate. This is a natural and smart place to start, but if you look only at interest rates you may be missing out on the big picture -- the influence of a bond’s price on its overall yield, commonly described as yield to maturity.
To understand the relationship between a bond’s interest rate and its yield to maturity (YTM), you must first understand bond structure. Bonds are loans: Investors give money -- the bond principal -- to corporations for a set period of time in exchange for a particular rate of interest, or a given interest schedule. If you buy a bond directly from the issuer, you pay “par value” for the bond, or the full value of the loan principal. This is typically expressed in units of 100 or 1,000, so you would pay $100 per bond upon issue. If you decide to sell the bond later, your portion of the loan is repaid to the second buyer, so that person pays you for the privilege of owning the bond and receiving the principal in the future. If interest rates have gone up or down since your original purchase, the bond may be more or less desirable than other bonds on the market. If this is true, you may get a premium for your bond -- a bit more than your original $100 -- or have to take a discount, something less than $100.
Bond interest rates -- also known as coupon rates -- are the amount of additional money you receive on an annual basis as payment for lending the issuer your principal. Interest payments are calculated on the par value of the bond, so always on that $100 or $1,000 per bond initial investment. A bond that pays 5 percent interest semiannually for six years would result in 12 payments of $2.50 per $100 of principal -- a total of $30 for the life of the bond.
Yield to Maturity
YTM starts with the interest rate and factors in adjustments for the purchase price of the bond. It also assumes that you will reinvest the interest payments you receive at a common, compounding rate. YTM calculations are complicated because they are moving targets -- the amount of compounding time, interest rates and prices are constantly changing. Most brokerage firms offer YTM estimates on potential purchases, and there are number of online calculators you can use to make estimates based on coupon rate and maturity date. In the example, if you paid a premium for the same six-year bond, say $101, your estimated YTM would decrease to about 4.8 percent, or about $28.80.
Factors that Affect Price and YTM
YTM can make a significant difference in the total amount of interest you pocket, so it is helpful to understand what influences the price of a bond and the YTM reinvestment interest rate. Everything depends on the price of money: the interest rate set by the Federal Reserve each quarter. That interest rate is how much banks must pay to get money, and all other rates flow from that. The Fed rate determines how much interest you can get for your money if you reinvest it or if you buy a different bond. If the Fed rate is low, most new interest rates will be low, and higher-paying bonds are more desirable. If the Fed rate goes up, other rates will go up as well, and bond rates that don’t match up are less desirable.