Since a sinking fund reduces credit risk to bond holders, these bonds can be offered with a lower yield than an otherwise identical bond with no sinking fund.
Bonds are issued by borrowers to raise funds for long-term investments; the main issuers of bonds in the U. Treasury securities are issued by the U. These are free of default risk , which is the risk that the investor will not receive all promised payments. They are not taxed by state and local governments, but are taxed at the federal level.
Another key difference between these securities is that Treasury bills are sold at a discount from their face value and redeemed at face value; Treasury notes and bonds are sold and redeemed at face value and pay semi-annual coupons to investors. Corporations can raise funds by issuing debt in the form of corporate bonds.
These bonds offer a higher promised coupon rate than Treasuries, but expose investors to default risk. The riskiest corporations offer the highest coupon rates to investors as compensation for default risk. A municipal bond is issued by a state or local government; as a result, they carry little or no default risk.
Occasionally, municipalities do default on their debts; in , the city of Detroit filed for bankruptcy as a result of being unable to pay its debts. Municipal bonds offer an extremely favorable tax treatment to investors. They are not taxed by federal, state or local governments as long as the bond holder lives in the municipality in which the bonds were issued.
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As a result, municipal bonds can be issued with very low yields. Foreign bonds are issued by foreign governments and corporations and are denominated in dollars.
If they are denominated in a foreign currency, they are known as eurobonds. Dollar-denominated bonds issued in the U. This formula shows that the price of a bond is the present value of its promised cash flows. The bond makes annual coupon payments. These results also demonstrate that there is an inverse relationship between yields and bond prices:. For a bond that makes semi-annual coupon payments, the following adjustments must be made to the pricing formula:. As an alternative to this pricing formula, a bond may be priced by treating the coupons as an annuity; the price is therefore equal to the present value of an annuity the coupons plus the present value of a sum the face value.
This method of valuing bonds will use the formula:.
An Introduction to Bonds, Bond Valuation & Bond Pricing
The bond in the previous example can be priced using this alternate bond valuation formula as follows:. A zero-coupon bond does not make any coupon payments; instead, it is sold to investors at a discount from face value. The difference between the price paid for the bond and the face value, known as a capital gain , is the return to the investor. The pricing formula for a zero coupon bond is:. What is the market price of this bond? In order to be consistent with coupon-bearing bonds, where coupons are typically made on a semi-annual basis, the yield will be divided by 2, and the number of periods will be multiplied by There are different types of yield measures that may be used to represent the approximate return to a bond.
These include:. This equals the rate of return earned by a bond holder known as the holding period return if:.
How coupon yield relates to your payout
It is impossible to solve for the yield to maturity algebraically; instead, this must be done using a financial calculator or Microsoft Excel. The variables in brackets fv, type and guess are optional values; the value of type is set to zero if it is not specified. Guess can be used to provide an initial estimate of the rate, which could potentially speed up the calculation time.
Note that either pv or fv must be negative, and the other must be positive. The negative value is considered to be a cash outflow, and the positive value is considered to be a cash inflow. Also note that entering semi-annual periods and coupon payments will produce a semi-annual yield; in order to convert this into an annual yield on a bond-equivalent basis , the semi-annual yield is doubled. For a bond that is callable, the yield to call may be used as a measure of return instead of the yield to maturity.
The process is similar to computing yield to maturity, except that the maturity date of the bond is replaced with the next call date.
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This is because yield to call is based on the assumption that the bond will be called on the next call date. The face value is replaced with the call price since this is the amount that the investor will receive if the bond is called. What is the yield to call? In this case, the bond will mature in eight years, but it can be called in three years. Popular Content See all. Leaderboard See all. IB Resources See all. Recent Jobs See all. RGTrader O. Rank: Monkey Bond Coupon vs. Bond Yield Technical terms surrounding bonds are numerous and can sometimes be confusing.
Coupon Rate on Bonds Definition The coupon rate of a bond represents the amount of actual interest that is paid out on a bond relative to the principal value of the bond par value. Bond Yields Explained The term bond yield can reference several different metrics - most notably the yield to maturity formula and the current yield calculation. Bond Yield to Maturity Formula A bond's yield to maturity estimates the bond's overall return assuming that the bond is held to maturity.
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For Bonds, Yield Doesn't Always Equal Return
Feb 4, - pm. If by Yield you mean Yield to Maturity, then it is the discount rate on the bond's cash flows. Hedge Fund Pitch for Interviews. As stated above, Coupon Rate is almost always constant; meaning whatever the coupon rate is at issuance is almost always going to be the coupon rate. Yield is measured a bunch of different ways. For more reading on YTM just Google it. Related Topic. Hedge Fund Interviews. No WSO Credits?
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How to Calculate a Bond's Current Yield
Yield to Maturity - Reinvestment Assumption. Interview Question on bonds. Which has higher yield? Notes for Technical Interview Questions.