Bond A: 3-year bond with a 3.00% coupon at price $94.50
Bond B: 3-year bond with a 10.00% coupon at price $113.77
I had an interesting conversation with a client who only wanted to purchase bonds under par ($100) and I wanted to demonstrate that the price of the bond isn’t as important as the Yield to Maturity (YTM) is.
As you might guess both those bonds have the same YTM of 5%. Meaning if you hold the each of those bonds you would get a return of 5% each year on your investment.
But now say Bond B had a price of $113.00 and YTM of 5.27%. My client wouldn’t entertain the idea of Bond B even though it has now a higher YTM than Bond A. Meaning Bond B now has a better return on investment!
Whether you pay a premium (above par) or have a discount (below par) on the bond just re positions when you get your value of the bond. Bond A gets its value at the end of the life of the bond date when it pays $100. Whereas Bond B value is paid off sooner, at every coupon payment as you receive the higher rate.
If there’s still confusion, check out the inner workings of a bond or give us a call.
The YTM is what lets bondholders sleep easy at night because you know precisely what return you’re going to get for your hard-earned money.