In the stock world, you have two returns to think about: capital gains and dividends. If the price of your stock goes up, you have a capital gain. If a stock pays a dividend, well, you get a dividend.
But bonds have six different types of returns, four of which are meaningful to the average investor: yield to worst, yield to maturity, yield to call, and current yield.
A fuller understanding of these returns can help you make better decisions about which bonds to own and when to own them to make the most money.
Today we’ll look at one of the most misunderstood aspects of bonds: current yield.
Bonds pay an annual, fixed-dollar amount called a coupon. A 7% coupon will pay $70 per year in two equal payments every six months.
The coupon is cast in stone and—unlike a dividend—it cannot be reduced, short of a default.
But because bonds fluctuate in value (not as much as stocks, in most cases, but there are some ups and downs), the payout percentage, or the current yield, fluctuates too.
And the fact that the current yield moves up when the price drops gives informed bond investors the opportunity to pick and choose their return percentage.
Here’s how this works…
When bonds are issued, their market price is measured against par—$1,000 per bond, or 100 in bond lingo. Bonds are reported to be at, above, or below par.
Let’s say that a 7% coupon bond is selling below par (less than 100 per bond) at 90. The $70 per year it pays to the holder is worth 7.7%, not 7%.
To calculate current yield, you simply divide the coupon rate by the market price (7/90 = 7.7%).
The dollar amount paid to you (in this case $70) remains the same, but the return percentage is higher because you paid less to get that $70 coupon.
The reverse is also true. If a bond is selling for more than par at 110 per bond at a premium of $100, the current yield is 6.36% (7/110 = 6.36%).
Because you paid more than par for the bond, your annual return percentage is lower than the 7% coupon.
And yes, there are situations when you should pay a premium for a bond. But if possible, you always want to buy a bond at a discount—at less than par.
Which brings us to discount bonds.
If you’re an income investor, you obviously want the highest yield—the biggest bang for your buck as possible. And I have seen some huge bangs!
Back in the oil crunch a few years ago, virtually every bond associated with crude oil was way down. How does $140 for a $1,000 bond sound?
The current yields were astronomical. At its low, a 4.5% gas driller bond I held through the crunch was paying a current yield of 32%.
And that same bond is now selling for around 104.
I’m not kidding when I say an informed bond buyer can make a lot of money.
But keep in mind that if a bond is selling for a big discount, there is always a reason. And few buyers have the nerve required to buy at big discounts.
That’s where we’ll start next time—when to buy at a discount.