Bonds are some of the most common forms of investment vehicles with guaranteed returns along with relatively low levels of risk. However, the knowledge of what bonds are and how to analyze them is critical to making the most investment in bonds.
In this piece, we will look at how to evaluate bond performance like a pro. We will learn some of the basics about bonds, including callable bond, as well as the main performance determinate metrics.
What Is a Bond? Understand the Bond Meaning
A bond is a debt instrument that pays for either an issue by a corporation or at the municipal or government level to obtain capital.
By purchasing this investment product, you would be in effect lending a sum of money to the issuer in exchange for a few interest payments (also called coupon payments), and at the bond’s maturity, the original principal would be repaid.
Bonds are then assigned with a certain fixed interest rate known as the coupon rate, which is paid to the bondholder at certain intervals and predetermined dates.
Evaluating Bond Performance
In the performance evaluation of any bond, there are a series of factors to consider. Thus here you go on how to analyze a bond’s performance like a pro:
1. Yield to Maturity (YTM)
One of the most important metrics for evaluating bonds is final yield (YTM). YTM describes the total return an investor should expect to earn if the bond is held to maturity and doesn’t default. It considers the current market price of the bond, coupon payments, and the time left to maturity.
2. Current Yield
Current yield is another important measure that is used to assess the performance of a bond. It is calculated by taking the annual coupon payment on the bond and dividing it by the current market price. This gives you an idea of how much you will earn as income concerning the price of the bond.
3. Credit Rating
The credit rating of a bond is another important consideration that factors into its evaluation; rating agencies like Standard & Poor’s, Moody’s, and Fitch categorize into various classifications a bond based on the reliability with which the issuer can pay back a bondholder. Bonds with these high credit ratings (AAA, AA) are considered quite secure, and these bonds have the potential to yield lower payoffs compared to junk bonds, which yield more.
What is a Callable Bond?
A callable bond is a kind of bond that can usually be redeemed by the issuer before its maturity date. As with the usual sense, callable bonds have a call option with which the bond can be bought back at a predetermined price (often at a premium over the face value) and at some specified time, usually exercised at times when interest rates have declined because it is cheaper for the issuer to refinance this bond at a lower rate.
Evaluating Factors in Callable Bonds
For example, there are additional considerations when evaluating the performance of a callable bond that one considers with traditional bonds. Here are the things to know:
Call Premium
The call premium is the amount above the bond’s face value that the issuer would pay to call the bond. This is meant to compensate the investor for an early call of the bond. If you own a callable bond, know the call premium and what it means to your total return should the bond be called.
Yield to Call (YTC)
The yield to call looks like the yield to maturity-YTM, except the bond is presumed to be called before maturity. You should look at both YTM and YTC for a callable bond when evaluating the total possible return.
Interest Rate Environment
Callable bonds are more often called when the interest rates fall. Thus, if the rates are declining now, the issuer may call the bonds back to issue further debt at lower rates. Consequently, investors need to be aware of the overall trends in interest rates at the time they are evaluating callable bonds.
Conclusion
Understanding bond meaning, metrics like YTM and current yield, and special features such as callable bonds are essentials for evaluating bond performance. Understanding this, you would be able to determine whether a bond truly fits your investment plan, risk tolerance level, and hoped-for returns.
