The lofty heights reached in interest rates caused by the rise in inflation over the past 18 months has developed a great awareness of fixed income investments and the attractive rates of return or income that are available. These rates of interest, rates of return, rents or income are all ways of refering to yield, for yield is all of these things.
The purpose of these articles is to shed light on various terms used to describe yield and how they pertain especially to fixed income investments.
Interest is the consideration paid by a borrower for the use of money. For a borrower, it is the cost of a loan, while for the lender it is the source of income.
The amount of interest paid or received depends on three factors - the principal amount of money on which the interest is computed, the rate of interest which is charged and the length of time over which the interest will be calculated.
There basically are two major types of interest. Simple interest if where the rate is always computed on an original principal. Under simple interest would fall ordinary interest which is computed on a 360-day year based on 12 months, each with 30 days. Also under this type would be exact interest where the rate is computed on a 365-day year or 366 days in leap year. Exact interest is used in computing the interest on U.S. Treasury notes and bonds. Simple interest is used in computing the interest on corporate, agency and municipal bonds.
The other major type of interest is compound interest where the interest is computed and added to the principal periodically. When the interest is added to principal it becomes principal. Future interest is then computed on this larger amount.
Coumpound interest may also be computed on a 363-day or an exact 365/366-day basis. Compounding provides for greater growth and was used until March by savings and loans associations to compute interest on money market certificates.
To appreciate the real power of compounding, consider these facts: If the interest on a sum of money is compounded at the same rate every six months, that sum of money will double every 11.7 years if the interest rate is 6 percent; every 8.8 years at 8 percent; and every 7.1 years if the interest rate is 10 percent.
Compounding helps to explain why the new Series EE savings bonds, which will come into being next Jan. 2, have an 11-year maturity. These bonds have no coupons. Instead they are purchased at approximately one-half of their maturity value. With an interest rate of 6 1/2 percent, they double in value in 11 years.
Before going further it would be helpful to touch a few basic ideas. The market value or quote on a bond is expressed as a percent of $1,000. If a bond is listed at 90, it is selling at $900. If it is selling at 105, the value will be $1,050. Should the bond be selling at par or 1000, the dollar price would be $1,000.
What is a fixed income security? A fixed income security represents debt. A corporation or a government may borrow money by a certain period time (maturity). For the use of that money, a set fee (interest) is paid to the lender (hence the designation fixed income) periodically over the life of the loan. When the loan expires, the borrowers repays the amount borrowed (principal) plus any outstanding interest to the lender.
Various types of bank loans, mortgages, preferred stocks, discounts paper and bonds are broadly designated fixed income securities.
In looking at fixed income securities, there is a confusing principle that must be understood. Yields and prices move inversely. A simple formula will help explain the relationship of price to yield but should not be used in calculating the market value of a bond.
The formula is: P equals A over I, with P, the dollar price or value of a bond; A, annual fixed income or return and I, market rate of return on a percentage basis) at a given time.
Therefore, if we have a bond with a 9 percent coupon returning a yield of 9 percent we see that the dollar price or value of the bond is $90 over .09 percent, or $1,000. If the market rate is 10 percent, the dollar value is $90 over .10 percent, or $900.
We can conclude by saying if the dollar price goes up, the yield or rate of return will come down and conversely if the price goes do the yield or return will rise. Actually the price and yield changes are different aspects of the same phenomenon of an inverse mathematical relationship.
In describing the various types of vield on fixed income securities, we will consider a bond selling at three different price levels: at par, at a discount from par and selling at premium above par.
When a person buys a fixed income security, he receives a rate of return or yield over the life of the security plus the principal at maturity. Consequently, the purchase price is not the sole determinant of the value of the security. Also involved are the length of time to maturity and the coupon rate of interest.
If we consider a 20-year 9 percent Treasury bond selling at $900 per bond, the following information can be stated:
The nominal yield, which is the coupon rate or cash rate is 9 percent ( $90 per year). The issuer, the Treasury, pays an annual rate of 9 percent ( $90) on the principal amount of $1,000 per year.
But the nominal yield is not the real yield to the buyer because in this instance he is paying$900 to receive $90 of income per year. His current yield on the Treasury is 10 percent. The current yield takes into account the coupon income received and the actual dollars invested (assuming the bond is held until maturity).
For the individual investor, current yield is probably the most important consideration as most individuals are concerned about spendable income, and current yield gives you that picture.
The yield expressed on common and preferred stocks is actually current yield. Quite simply, in the case of such stocks, it is the dividend divided by the cost per share. If you purchase a $20 stock that pays a $1.00 dividend per year, your yield or current return is 5 percent.
The next article will consider not only the price paid to receive income but whether or not that price is above par (a premium) or below par (a discount), and their effect on yield.