The Federal Reserve, commensurate 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 led to large gains in bond prices. Therefore, most bonds are now trading at what is 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 in place of its yield.
Bonds are normally issued in $1,000 face value increments. An attachment selling at below face value is considered selling at a "discount" ;.An attachment selling at its face value is considered selling at "par", and a bond selling for significantly more than its face value is considered selling at a "premium" ;.Do not confuse these terms (discount, par, premium) with levels of quality or value. An attachment selling at reasonably limited does definitely not allow it to be better or for that matter higher priced on a relative basis than the usual bond selling at par or perhaps a discount. Those terms are only used to explain the bonds current price relative to its face value. So, if the dollar price of a bond really doesn't express its' relative value, how do an investor compare bonds? That answer may lie in the bond's yield.
Yield takes under consideration the purchase 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 emphasizing the dollar price. Yield is an important tool to gauge the return of 1 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 own investment. Professional dealers and traders, when buying and selling bonds together, usually quote prices in yields not dollars; yield offers you an immediate check out the relative value in comparison to other bonds. When considering yields, here are some useful tips to find value:
- Compare the yield of the bond you are considering to other similar investments. Bonds aren't as liquid as stocks and, often times, you will find value by comparing.
- When evaluating various maturities of the same bond, go through the incremental yield (the spread) you'd be receiving by buying the longer maturity and be sure you feel it's worth the extra risk. Yields are quoted in basis points: 1 basis point is 1/100th of 1 percent; 100 basis points is corresponding to 1%. For instance, if you should be 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 things being equal. If you should be evaluating a diminished rated bond, make certain the extra yield you'd get (the spread) with the low rated bond may be worth the extra risk.
- Don't get swept up in a particular maturity date. Due to the way bonds are traded, it's very possible to obtain a bond with a shorter maturity that gives less expensive, other things being equal.
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- In this interest rate environment, consider buying higher coupon bonds (Premiums) which are generally more defensive should interest rates rise prior to when anticipated. But bear in mind that when interest rates remain as is or go lower for an extended period of time, bonds with call features might be redeemed prior to when everything you had anticipated.
