Understanding Interest-Rate Risks and Yields

Like all bonds, corporates tend to rise in value when interest rates fall, and they fall in value when interest rates rise.

Usually the longer the maturity, the greater the degree of price volatility. By holding a bond until maturity, you may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because you will receive the par, or face, value of your bond at maturity.

Understanding Interest-Rate Risk

Some investors are confused by the inverse relationship between bonds and interest rates – that is, the fact that bonds are worth less when interest rates rise. But the explanation is essentially straightforward: When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down. When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding ones worth more. Hence, their prices go up.

As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it. Various economic forces affect the level and direction of interest rates in the economy. Interest rates typically climb when the economy is growing, and fall during economic downturns. Similarly, rising inflation leads to rising interest rates (although at some point, higher rates themselves become contributors to higher inflation), and moderating inflation leads to lower interest rates. Inflation is one of the most influential forces on interest rates.

Understanding Yields

Yield is a critical concept in bond investing, because it is the tool you use to measure the return of one bond against another. It enables you to make informed decisions about which bond to buy. In essence, yield is the rate of return on your bond investment. However, it is not fixed, like a bond’s stated interest rate. It changes to reflect the price movements in a bond caused by fluctuating interest rates. Here’s an example of how yield works: You buy a bond, hold it for a year while interest rates are rising and then sell it. You receive a lower price for the bond than you paid for it because, as indicated above under “Understanding Interest-Rate Risk,” no one would otherwise accept your bond’s now lower than-market interest rate. Although the buyer will receive the same dollar amount of interest you did and will have the same amount of principal returned at maturity, the buyer’s yield, or rate of return, will be higher than yours was – because the buyer paid less for the bond. ]

There are numerous types of yield, but two – current yield and yield to maturity – are of greatest importance to most investors.

Current Yield
The current yield is the annual return on the dollar amount paid for a bond, regardless of its maturity.
If you buy a bond at par, the current yield equals its stated interest rate. Thus, the current yield on a par value bond paying 6% is 6%.

However, if the market price of the bond is more or less than par, the current yield will be different. For example, if you buy a $1,000 bond with a 6% stated interest rate after prevailing interest rates have risen above that level, you would pay less than par.

Assume your price is $900. The current yield would be 6.67% ($1,000 x.06/$900).

Yield to Maturity
A more meaningful figure is the yield to maturity, because it tells you the total return you will receive if you hold a bond until maturity. It also enables you to compare bonds with different maturities and coupons.

Yield to maturity includes all your interest plus any capital gain you will realize (if you purchase the bond below par) or minus any capital loss you will suffer (if you purchase the bond above par).

Don’t buy on the basis of the current yield alone, because it may not represent the bond’s real value to you.

Understanding “Call” and Refunding Risk
One of the most difficult risks for investors to understand is that posed by “call” and refunding provisions. If the bond’s indenture (the legal document that spells out its terms and conditions) contains a “call” provision, the issuer retains the right to retire (that is, redeem) the debt, fully or partially, before the scheduled maturity date.
For the issuer, the chief benefit of such a feature is that it permits the issuer to replace outstanding debt with a lower interest-cost new issue.

A call feature creates uncertainty as to whether the bond will remain outstanding until its maturity date. Investors risk losing a bond paying a higher rate of interest when rates have declined and issuers decide to call in their bonds. When a bond is called, the investor must usually reinvest in securities with lower yields. Calls also tend to limit the appreciation in a bond’s price that could be expected when interest rates start to slip.

Because a call feature puts the investor at a disadvantage, callable bonds carry higher yields than noncallable bonds, but higher yield alone is often not enough to induce investors to buy them. As further inducement, the issuer often sets the call price (the price investors must be paid if their bonds are called) higher than the principal (face) value of the issue. The difference between the call price and principal is the call premium.

Generally, bondholders do have some protection against calls. An example would be a bond that has a 15-year final maturity, non-call two years. This means the investor is protected from a call for two years, after which time the issuer has the right to call the bonds.