Corporate Bond Yields
Corporate bonds are IOUs companies issue to borrow money, usually for capital investment. Bonds pay a fixed annual interest called the coupon rate. Typically, corporate bonds pay higher rates than government bonds like Treasury bills, which makes them attractive for investors. However, while corporate bonds have less risk than stocks, they tend to have lower returns over the long run. Understanding corporate bond yields is not hard, but it is complicated by the fact that the yield you get depends on the price you pay for a bond, and that varies as bonds are traded.
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Identification
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Understanding corporate bond yields starts with knowing how bonds work. A corporate bond is usually issued with a face (par) value of $1,000 or $5,000. The face value is the amount the company must repay when the bond matures. The coupon rate the bond earns is fixed. For example, a $1,000 par value bond might have a coupon rate of $80/year (8 percent fixed interest). However, the actual yield depends on the price of the bond, not its face value, and takes two forms: simple yield and yield to maturity (YTM).
Simple Yield
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Corporate bonds are traded much like stocks, and their price varies in response to market forces. Unless a bond is very close to maturity, the price is rarely the same as the face value. If it is trading for more than the face value, it's said to be selling "at a premium." A bond selling below face value is "at a discount." The yield is the actual interest rate an investor gets based on the price paid for the bond. For example, suppose the $1,000 bond with the $80 coupon rate is selling for $800. The actual rate of interest is $80/$800 or 10 percent, not the nominal 8 percent of face value.
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Yield to Maturity
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Corporate bonds are issued for periods of up to 30 years (or even longer on occasion). If an investor plans to hold a bond until maturity, then the difference in price and the face value she will receive when the bond is redeemed needs to be factored in with the yield to find the true return on investment. Calculating this yield to maturity is complicated and you need a bond yield calculator (see link in "Additional Resources," below). The basic pattern's simple, though. If the bond is bought at a discount, the YTM is higher than the yield, because you will receive more for the bond than you paid, plus the annual earnings. If the bond is bought at a premium, your YTM is less than the yield because at maturity the company pays the face value, not the premium price.
Function
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The single biggest factor influencing corporate bond yields and therefore yields is the prevailing interest rate. Corporate bonds must compete with other securities for investors' money. When interest rates rise, corporate bond prices fall until yields are in line with the new interest rates. The same is true in reverse: If interest rates fall, relatively high bond yields increase demand, causing bond prices to rise and yields to fall. News of changes in the prime rate, inflation or anything else that affects interest rates is thus important to corporate bond owners.
Risk
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Corporate bonds from two different companies with the same coupon rate may have different yields. This reflects the other major factor affecting corporate bond yields: risk. The more risk a bond represents, the higher the yield has to be to compensate. Uncertainty equals risk for investors. For example, a long-term bond is considered higher risk than one with a near-term maturity date because it is more difficult to know what a company's circumstances will be many years in the future. More important is the creditworthiness of the issuing company. That's why bond ratings provided by independent rating firms like Moody's or Dun & Bradstreet are so influential. These ratings estimate the credit risk a company represents for a bond investor. A high- ("blue chip") rated bond has low risk and a lower yield than a low-rated "junk bond."
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