The following section outlines common terminology associated with bonds and debentures:
-Short-term bonds mature in 3 years or less,
-Medium term bonds mature between 3 and 10 years,
-Long-term bonds mature in 10 years or longer.
Example: If an investor pays $950.00 for a $1,000 Par/Maturity Value bond that matures in three years and it has a 5.0% Coupon, then the Yield to maturity can be estimated as follows. To keep the calculation simple, the coupon rate is assumed to be compound interest, which assumes the investor will reinvest the interest income at the same coupon rate:
1) The investor will earn $50.00 per year ($1,000 X 5.0%) for a total interest income of $150.00 over the three-year period.
2) If held to maturity, the investor will also earn $50.00 ($1,000 less $950).
3) As a result the investor will have earned $200.00 or 21.0% ($200 divided by $950) over the three years the bond was owned.
4) Therefore, from the date of purchase, the yield to maturity would be 7.0% per year (21% total return divided by 3 years).
Note: If this bond is held in a taxable account, the investor’s after-tax return would be enhanced because the $50.00 difference between the bond’s Par/Maturity value and the price paid will be taxed preferentially as capital gains.
Another to demonstrate how important a bond’s purchase price is in determining an investor’s rate of return, consider a bond purchased at a premium to the bond’s Par/Maturity value:
1) The same three-year, 5.0% coupon, $1,000 Par value bond is purchased for $1,050.
2) The investor will earn $50.00 per year ($1,000 X 5.0%) for a total interest income of $150.00 over the three-year period.
3) If held to maturity, the investor will also lose $50.00 of tax-paid capital ($1,000 less $1,050).
4) As a result the investor will have earned $100.00 or 9.5% ($100 divided by $1,050) over the three years the bond was owned.
5) Therefore, from the date of purchase, the yield to maturity would be 3.17% per year (9.5% total return divided by 3 years).
Note:If this bond is held in a taxable account, the investor’s after-tax return would be less than the calculated yield to maturity because the $50.00 difference between price paid and the bond’s Par/Maturity value is actually returned to the investor, over the life of the bond, in the form of taxable interest income.
For additional details on bond pricing, see Bond Market and Pricing Issues.
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