Yields vs interest rates- how to interpret bond offers

Have you ever received a bond offer and notice more than one 'return' quoted? Bonds are instruments that pays a set rate of interest at set intervals over a specified period of time/tenor and repays the principal at maturity. For example an investment of TT$100,000 in a bond might have an interest rate of 5%, paid semi-annually, using a 30/360 day basis and mature in 5 years.

This means that you pay TT$100K now in exchange for $2,500 every six months until the end of year 5, where you will receive the principal of 100K + the last $2,500 interest payment. The principal amount is sometimes referred to as the the face value.

In this case, the bond broker/investment firm will quote you the interest rate as 5% and the gross (before fees) yield as 5%.

However, you can buy a bond at above or below 100 (also known as par). Let's say you pay a premium for the bond at 100.50. This means you pay 50 cents extra for every $100 of the bond you purchase. The cash flows as follows:

In this case, you pay $100,500 upfront to receive $2,500 every six months until the end of year 5, where you will receive the principal of 100K + the last $2,500 interest payment.

Now that you pay a higher price than 100.00, the interest rate and the yield of the bond is different. Intuitively you know your yield is lower than 5% because of that premium you paid.

As you can tell from this simple example, comparing returns on bonds using the interest rate/ coupon can be misleading so investors should compare bonds using the net yield to maturity (YTM). We can think of the yield to maturity as the total return (annualized) expected on a bond if the bond is held until maturity.

To help you in the decision making process for bonds offers (from any broker), I've put together a comparison example below:

All 3 bonds follow the same 30/360 basis of interest payments and pay coupons semi-annually. 

Bond A: Priced at 100.00 , 7% interest rate, tenor: 3 years 

Bond B: Priced at 100.50, 5.35% interest rate, tenor: 5.25 years 

Bond C: Priced at 96.00, 5% interest rate, tenor: 2 years. 

At first glance Bond A is most attractive as it earns the highest interest rate but that bond has a different price and tenor compared to the other two. So to compare the bonds on an "equal footing" we calculate the yield to maturity aka total return for each bond assuming all is held to maturity using the following formula- 

Working backwards for YTM for these bonds reveals bond C offers the highest yield. 

All brokers should quote the offer yield and this should be the rate we use to get an accurate reflection of the return to the investor (if the intention is to hold the bond to maturity). 

Of course while C may have the highest yield, it may not be the most attractive depending on factors like credit risk and the market dynamics at the time it was offered, etc. Also some traders may intend to hold a bond for a shorter time than maturity with the intention of realizing a capital gain (the price of bonds move regularly). I am available to discuss these factors for any of the bonds I offer or explore the local or international markets for bonds that may fit your profile/goal.

I hope this illustration was helpful for you as you seek to optimize your portfolio return.