Bursting the Bondholder's Bubble: The Truth About Coupons
Many Investors Don’t Understand the Return Dynamics of Bonds
You don’t need to work in the investment industry to know that the last decade has been a discouraging environment for bonds. From 2009 to 2016, 3-month treasury rates were anywhere from 0.00% to 0.55%. It hasn’t been until this last year that rates have ticked up periodically, ending at 1.65% in February*. Some investors have learned to cope with the reality of low bond rates waiting patiently for yields to increase. Others have made the decision to chase higher yields and increase risk, often unwittingly. And then there are people like our friend. We had a conversation with him about a year ago and have since then realized that a decent number of investors (including some professionals) don’t understand the return dynamics of bonds. Below is a quick glance into part of the conversation.
Friend: I keep hearing how low bond yields have been over the years. I’m glad I have my money with my current manager.
KPP: Why is that?
Friend: They are getting me 5% on all my muni bonds!
KPP: Wow, 5%? That seems a little too good to be true.
Friend: What do you mean?
KPP: Well, are you holding high-risk bonds?
Friend: Nope. They are high-quality bonds and I see that I’m getting 5%.
KPP: I hate to burst your bubble, but to get yields like that in this environment you must be taking on extra risk somewhere. Are you sure the 5% they mentioned isn’t in reference to the coupon payment?
Friend: (clearly frustrated) What do you mean? 5% is 5%, right?
KPP: Well, a lot of bonds have 5% coupon payments, especially muni bonds, but that doesn’t mean you’re getting 5% return each year.
Our friend had enough at this point and nicely ended the conversation, either realizing he had more questions to ask his adviser or wishing to maintain the ideal bond world he believed in.
The Bond’s Current Yield is Not Always the Return
Bond returns can be a difficult topic to grasp and many people fall into the misconception that a bond's current yield or coupon payment is the return to the investor, but that is generally not the case. Similar to taking into consideration dividends and changes in price when determining the total return of a stock (see our Dangerous Devotions to Dividends blog), you must also consider coupon payments and changes in market value of the bond when determining the total return of a bond. When purchasing a newly issued bond, or one in secondary markets, there is a multitude of factors that affect its market price, including, but not limited to, the par value, coupon payment, maturity date, and credit quality.
The Factors that Affect Returns
Let’s review these factors before we dive any deeper:
Par value is the amount of money that the investor is entitled to when the bond has fully matured. It tends to equal $100 or $1,000 per bond.
Coupon payment is income paid as a percentage of the par value. These tend to be paid semi-annually. Example: If you have a bond with a $100 par value and a 5% coupon you will receive a payment of $2.50 every 6 months. Please note that the coupon payment is not your return on your bond investment.
Maturity date signals to the investor when the bond issuer will pay back the par value and the final coupon payment. As bonds get closer to their maturity date, the market value of the bond tends to gravitate closer to its par value (see Figure 1).
Credit quality reflects the level of confidence a rating agency has in the issuer of the bond and its ability to meet the coupon payments and return the par value upon maturity.
Generally, the fixed income market is also very sensitive to the current Federal Reserve interest rate (mentioned at the top of this blog), which tends to set the market rate for all bonds in conjunction with the other factors discussed above. Because there are so many influencing factors, many more than what we have laid out in this post, all bonds will have different price points. Most often, bonds will sell either at a price above their par value (the industry calls this selling at a premium), or at a price below their par value (the industry calls this selling at a discount), but rarely do you see bonds sell at their par value.
A Case Study
However, for the sake of example:
John, the investor, wants to buy bond XYZ, a high-quality bond with a coupon payment of 5%. It matures in 10 years and holds a par value of $100. However, the market yields for bonds of the exact same credit quality and maturity is 4%. Since the XYZ bond is paying 5%, John is willing to pay more than the par value to purchase that bond. This would mean XYZ is a bond selling at a premium.
| XYZ Bond | Market Bond | |
|---|---|---|
| Coupon Payment (semiannual) | $2.50 | $2.00 |
| Number of Payments | 20 | 20 |
| Par Value | $100 | $100 |
| Calculated Market Price | $110 | $100 |
Assuming all else equal, as time passes, the market value of the bond will slowly decrease and move towards its par value (i.e., $100) until its maturity date (see Figure 1). Therefore, while John held bond XYZ, he received the 5% coupon payments but also lost value because the premium paid for the bond declines until the bond matures (i.e., $10 lost, in this example)**.
Put simply, don’t let those bond managers sell you on coupons alone! You need to know what you paid, the likelihood of getting future coupon payments and the par value, and how long until you get the par value back. Knowing these details allows you to effectively evaluate your bond and/or manager.
Figure 1: Used to illustrate the price change of a bond.
* Daily treasury yield curve rates provided from the U.S. Department of the Treasury.https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield
**Please note that the price of the bond is not a dollar-for-dollar difference between coupon payment. Timing of payments affects the price of the bond.
