The Federal Reserve, in keeping 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 resulted in large gains in bond prices. Therefore, most bonds are actually trading at what's referred to as a "premium" ;.Premium bonds are misunderstood by the retail investor who typically focuses their attention primarily on the dollar price of the bond instead of its yield. bonds
Bonds are normally issued in $1,000 face value increments. An attachment selling at below face value is reported to be selling at a "discount" ;.An attachment selling at its face value is reported to be selling at "par", and a bond selling for a lot more than its face value is reported to be selling at a "premium" ;.Don't confuse these terms (discount, par, premium) with degrees of quality or value. An attachment selling at reasonably limited does definitely not make it better or for example higher priced on a family member basis than a bond selling at par or perhaps a discount. Those terms are merely used to explain 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 price, the maturity, and the coupon rate. Yield is an incredibly important concept in bond investing that is typically overlooked by retail investors, who make value judgments by solely concentrating on 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]. Basically, "yield" may be the rate of your return on your investment. Professional dealers and traders, when buying and selling bonds to one another, usually quote prices in yields not dollars; yield offers you a sudden research the relative value compared to other bonds. When taking a look at yields, below are a few useful tips to look for value:
- Compare the yield of the bond you're considering to other similar investments. Bonds are not as liquid as stocks and, often, you'll find value by comparing.
- When evaluating various maturities of the exact same bond, go through the incremental yield (the spread) you would be receiving by purchasing the longer maturity and ensure you feel it's worth the extra risk. Yields are quoted in basis points: 1 basis point is 1/100th of just one percent; 100 basis points is add up to 1%. For instance, if you are 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 extra risk.
- Higher rated bonds will most likely offer a lower yield, other items being equal. If you should be evaluating a lesser rated bond, make sure the extra yield you would get (the spread) with the reduced rated bond is worth the extra risk.
- Don't get swept up in a certain maturity date. Due to the way bonds are traded, it's very possible to obtain a bond with a smaller maturity that gives less expensive, other items being equal.
- In this interest rate environment, consider purchasing higher coupon bonds (Premiums) which are generally more defensive should interest rates rise prior to when anticipated. But remember when interest rates remain as is or go lower for a longer time period, bonds with call features may be redeemed prior to when what you had anticipated.
