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A bond is a certificate of debt sold to raise
capital. When you buy a bond, you are lending your money to a business or
government. The bond issuer (seller) promises to repay you the original
amount of the bond (the principal) at a specific future date. The
time when the bond is scheduled to be paid back is known as the bond's
maturity date.
The face value of a bond is known as its par. A bond's par is the same as its issue price and the price to be repaid when the
bond matures (reaches its maturity date).
Bonds also earn interest. The rate at which a bond earns
interest on its par is known as its coupon rate.
The amount of return you make on a bond is measured by its
yield-to-maturity (YTM). Yield-to-maturity is the total amount of
interest on a bond over its entire lifespan. It tells you how much you
will make on the bond if you hold it until maturity or until it is called
(bought back). A bond's yield-to-maturity includes any interest on the
bond's coupon rate as well as any loss or gain from buying the bond above or
below its face value. The calculation for YTM is based on a bond's coupon
rate, time to maturity, and market price. Although the exact calculation
is tedious, there is a simple approximation you can use to calculate the yield-to-maturity.
I = the annual interest (in dollars)
Pb = bond market price
n = number of years to maturity |
