Bonds – Understanding yield versus interest rate
When discussing fixed income securities, it is important to differentiate between the interest rate and the yield that is expected to be earned on a particular investment. An investor’s yield is a more important consideration than the interest rate a fixed income security is paying.
This is primarily due to the fact that securities are often worth more or less than their stated principal values depending on what interest rate the security is paying versus current market interest rates for comparable securities.
Based on whether a specific security is paying the same, a higher or lower interest rate than investors are currently demanding for similar securities will determine whether the security will sell at par value or a premium or discount to its par value in cedis.
A security that is worth par value means that the interest rate being paid to investors on the security is equal to the interest rate that investors are currently demanding to be paid for similar securities based on current market conditions.
For example, if an outstanding bond with a principal value of GHS 1,000 (its par value) is currently paying 8 percent interest, and similar termed bonds of similar risk are also paying 8 percent, then the bond will be worth GHS 1,000, or par value. In this case, an investor can buy this bond for GHS 1,000, earn an 8 percent interest rate (and 8% yield) each year, and receive GHS 1,000 when the bond matures and is repaid by its issuer.
Now let us consider an example when a bond will sell at a premium to its par value in cedis. Assume a 10-year bond was sold 3 years ago by a corporation and today has 7 years remaining until it reaches maturity and repays its investors.
Also assume that this now 7-year bond is paying an interest rate of 8 percent, and its par value (the amount of principal it repays at the time of maturity) is GHS 1,000 per bond. If the bond is scheduled to pay interest once a year and all principal at the time of maturity, investors will be paid GHS 80 per year in interest and GHS 1,000 at the time of maturity. But this bond was issued 3 years ago. Market interest rates change constantly and can move dramatically over a 3-year period.
Assume that today while the bond having 7 years remaining is paying an interest rate of 8 percent, a similar 7-year bond is paying an interest rate of only 6 percent. This would mean that our bond is paying more interest to investors than current market conditions require. So why would the bond still sell for GHS 1,000? It would not.
Rather, the bond would sell for something more than GHS 1,000, say GHS 1,110, so that the yield investors receive is 6 percent (the current market rate). In this case, we say that our bond is selling or is valued at a premium. A premium means that a fixed income security is worth more than its par value in order to lower its yield to investors to be more comparable to current market interest rates.
A fixed income security would be valued at a discount if current interest rates were higher than the interest rate being paid by the security being evaluated in cedis. For example, if our 7-year remaining bond was paying its 8 percent interest rate, but the current market rate for a similar 7-year bond was 10 percent, then our bond is paying a lower interest rate than the interest rate that investors are currently demanding for similar securities.
This means that our bond should sell for less than par in order to increase the yield to its investors. Therefore, instead of the bond being worth its par value of GHS 1,000, it would be worth something less, like ¢900. A discount means a fixed income security is selling below its par value in order to raise its yield to investors to be more comparable to current market interest rates.
