Office Hours: The Bond Market

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.