Yield, Duration and Ratings of Bonds
The yield of a bond is, roughly speaking, the return on the bond. The yield is expressed as an annual percentage of the face amount. However, yield is a little more complicated (and therefore more useful) than the coupon rate. There are several different measures of yield: nominal yield, current yield, and yield to maturity.
- Nominal yield is equal to the coupon rate; that is, the return on the bond without accounting for any outside factors. If you purchase the bond at par value and hold to maturity, this will be the annual return you receive on the bond.
- Current yield is a measure of the return on the bond in relation to the current price.
- Yield to maturity is the overall return on the bond if it is held to maturity. It reflects all the interest payments that are available through maturity and the principal that will be repaid, and assumes that all coupon payments will be reinvested at the current yield on the bond. This is the most valuable measure of yield because it reflects the total income that you can receive. If you purchase the bond at a discount, yield to maturity will reflect the fact that at maturity you will have additional income because of the difference between the price paid and the principal returned. For example, if you purchase a $1,000 par value bond for $800, you have $200 extra in income at maturity. The calculation is slightly different if the bond is purchased at a premium, but it takes into account the extra amount paid for the bond.
DurationDuration is a weighted measure of the length of time the bond will pay out. Unlike maturity, duration takes into account interest payments that occur throughout the course of holding the bond. Basically, duration is a weighted average of the maturity of all the income streams from a bond or portfolio of bonds. So, for a two-year bond with 4 coupon payments every six months of $50 and a $1000 face value, duration (in years) is .5[(50/1200)] + 1[(50/1200)]+ 1.5[(50/1200)]+ 2[(50/1200)] + 2[(1000/1200)] = 1.875 years. Notice that the duration on any bond that pays coupons will be below the maturity because there is some amount of the payments that are going to come before the maturity date. In this example, the maturity was 2 years. Investors use duration to measure the volatility of the bond. Generally, the higher the duration (the longer you need to wait for the bulk of your payments), the more its price will drop as interest rates go up. Of course, with the added risk comes greater expected returns. If an investor expects interest rates to fall during the course of the time the bond is held, a bond with a long duration would be appealing because the bond's price would increase more than comparable bonds with shorter durations.
RatingsAs discussed earlier, the yield of a bond will be influenced by the risk of default by the issuer. Naturally, there is far more risk associated with a small telecom company's bond than with the federal government's. Investors need to be compensated for the additional risk. Conveniently, there are bond rating services that do most of the legwork for you in determining the default risk for a given issue. The biggest names in bond ratings are Moody's Investors Services, Fitch IBCA, and Standard &Poor's. These companies analyze each issuer's financial position and assign a letter grade that ranks their likelihood of successfully repaying the debts incurred. The basic ranking system is as follows (each ranking system is a little different, but this should be a useful general guide):
- AAA - Highest quality, with the least likelihood of default.
- AA - High likelihood of repayment; together with AAA bonds these are considered "high grade bonds."
- A - Quite safe, thought to be a good medium-grade bond. There is some risk if conditions become quite difficult.
- BAA or BBB - Somewhere in the middle, they aren't extremely safe, but they are not a great risk either. Anything with BAA or higher is called an "investment grade bond."
- BA or BB - The future of this issuer is somewhat in doubt. Bonds at or below this ranking are called "speculative."
- B - These bonds are fairly speculative. Significant risk of default if conditions become difficult.
- CAA or CCC - These bonds are highly speculative. Bonds with this ranking or lower are considered junk bonds.
- CA or CC - Significant risk of default, highly speculative.
- C - In some rankings this is just another grade of junk bonds, others use it to mean that these bonds are no longer paying interest or are in default already.
- D - Bonds that have been defaulted on.
- N - Not rated, usually because the company did not want the issue to be rated or because the company is too new to have a credit history to base a rating on.