Office Hours: The Bond Market

In Intro to the Bond Market, you learned the basics about bonds and how they differ from stocks. But what if you’re investing and you’ve got a few possible companies to choose from? How would you evaluate which bond is likely to be the best investment for you?

Let’s look at an example from our bond market practice questions:

Suppose you’d like to invest in a company and you’ve narrowed your choice down to three firms: Company A is offering a zero-coupon bond with a face value of $1000 to be repaid in 1 year for $963. Company B has the same face value and maturity date but sells for $871. And company C also has the same face value and maturity but sells for $985. In which would you rather invest?

If some of the terms have you scratching your head, don’t worry! Go ahead and start this Office Hours video. Mary Clare Peate from the MRU team will cover the jargon and give you the tools you need to master the problem on your own.

Additional practice questions: http://bit.ly/29R04Ba

Intro to the Bond Market: http://bit.ly/29RP0xG

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Today we'll take a closer look
at the bond market.

Suppose you'd like to invest in a company

and you've narrowed your choice
down to three firms.

Company A is offering a zero coupon bond

with a face value of $1000 to be repaid
in one year at a price of $963 today.

Company B has the same
face value and maturity date,

but sells for $871 today.

And Company C also has
the same face value and maturity,

but sells for $985.

What is the applied rate of return,
or the yield, of each bond?

In which would you rather invest?

As always, try to answer
this question by yourself.

Check out our video on bonds,
attempt the Problem,

and then come back and we can
work the problem together.

This problem is
surprisingly straightforward.

It's just the jargon that makes it seem difficult.

Mature bonds, zero coupon,
rates of return?

So let's quickly break
these concepts down.

A bond's maturity date is

when the face value of the bond
is paid to the bond holder.

In our example, all three bonds
mature in one year.

And so their bond
holders will receive $1000 for the face

value of each bond at the end of that one
year. Coupon payments are periodic

interest payments that the bond holder
receives while the bond matures. So a zero

coupon bond, in our example today, means
you don't get payments while the bond

matures, you are just paid the face value
of the bond at the maturity date. And

finally, what's a bond's rate of return,
or yield? It's just what you stand to gain

or lose from purchasing this bond,
expressed as a percent of your initial

investment. Simply divide the gain or loss
of the investment by the initial price you

paid for the bond to find that implied
rate of return, or the yield. So, now that

we've deciphered all that jargon, let's
plug our first company into this equation.

Company A's bond rate of return: what will
you gain? $1000, or the face value, minus

$963, your initial investment, equals a
gain of $37. Divide that gain by $963,

what you initially paid for the bond,
which equals a 3.8% rate of return. Just a

note here, this calculation becomes much
more difficult if the bond were to mature

after several years. For those of you who
would like to tackle this challenge, I've

included it as a practice problem at the
end of this video. Given that the other

two bonds have the exact same
characteristics, zero coupons and a one

year maturity date, we can speed through
these calculations. Company B's bond rate

of return is: the investment gain, $129,
divided by the initial investment, $871

for a rate of return of 14.8%. And finally
Company C's bond rate of return: a gain of

$15, divided by $985, that initial
investment, for a 1.5% rate of return. We

now have our three rates of return. It
seems clear that we'd want to invest in

Company B, after all, its rate of return,
or yield, is so much higher than the other

two investments. But stop and ask yourself
this question, “Why on Earth is Company B

offering such a high yield? And why isn't
everyone jumping on this great deal?” Risk!

Even though bonds are safer than stock
holders because bond holders are paid

before shareholders, there can
still be risk of default.

Equally risky assets must have
the same rate of return.

If they didn't, everyone
would buy the bond with the

higher rate of return until the prices
equalized. So we basically know that

Company B has a lot more risk than the
other two companies. Company C, on the

other hand, is the least risky. So, which
company would you prefer to invest in?

Well, there isn't actually a clear right
answer here. It in part depends on your

preference for risk. As always, please
let us know what you think. And, if you'd

like more practice, check out our practice
problems at the end of this video.

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