Bond Coupon Rate and Yields

After starting this blog back in 2016, I realised that I have yet to write a single post on bonds. Let me start the bond ball rolling by explaining bond coupon rate and the two common bond yields used, current yield and yield to maturity.

Coupon Rate and Current Yield

The coupon rate of a bond is always calculated based on its par value. If a $1,000.00 bond’s annual coupon rate is 5%, the bondholder will get $50.00 per year (5% of $1,000.00 = $50.00).

Like any investments, the market value of a bond will fluctuate depending on its demand and supply. Since the coupon rate is fixed, we could use current yield calculations to see if it is higher or lower than the coupon rate.

If the market price of the bond is $950.00, the current yield would be $50.00/$950.00 x 100% = 5.26%.

If the market price of the bond is $1,050.00, the current yield would be $50.00/$1,050.00 = 4.76%.

From the calculations, it is observed that if the bond is at a premium (above the par value), the yield would be lower than the coupon rate, and vice versa if the bond is at a discount (below the par value).

Yield to Maturity

Another way to look at bond yields would be the yield to maturity (YTM). According to Investopedia, YTM is “the total return anticipated on a bond if the bond is held until it matures”¹, and some bond investors prefer to look at YTM as it could be used to compare with other bonds that have different coupon rates and tenures.

Calculating YTM is a bit more difficult than calculating current yield as the former involves present value calculations, but the good news is there are online calculators available.

Providing some examples, if a $1,000.00 bond with a 5% coupon rate (paid annually) and 10-year tenure is priced at $950.00 in the financial markets, the YTM would be 5.67%. If the same bond is priced at $1,050.00 instead, the YTM is 4.37%.

Relationship Between Coupon Rate, Current Yield and YTM

From the above example calculations, we can clearly see the relationship between the coupon rate, current yield and YTM. Below shows the relationship summary conveniently.

Bond priced at par: coupon rate = current yield = YTM

Bond priced at premium: coupon rate > current yield > YTM

Bond priced at discount: coupon rate < current yield < YTM

1 – Investopedia. Yield to Maturity. https://www.investopedia.com/terms/y/yieldtomaturity.asp. (accessed 27 Mar 2018).

Did You Miss The Sale?

Everyone loves a sale. It is during a sale period that you can shop for things at a bargain. There are sale periods in the financial markets as well, but there is a huge difference; Department stores will tell you when the sale starts and how long it will last, but financial markets will never tell you such things.

The most recent sale period was during the market downturn in early February. As above, there was no announcement that share prices were going to take a dip, and also in my post here I had stated that we do not know how long this was going to last.

Looking back, the question asked was did we miss the sale during those few days? For me, it would be yes, for I had only bought into one REIT during that period, and before I could deploy my resources, things were going back to normal.

However, we could learn something from this episode and better prepare ourselves for the next sale. Like an avid shopper, we could draw up a wishlist or shortlist of sorts.

Prepare a Shortlist

In my ebook, I had mentioned about preparing a shortlist of the financial instruments available for your Bedokian Portfolio¹. The shortlist contains counters that you are interested in, but it is not at the right time to enter. Also, it could be a list of your existing counters in your portfolio with a new target price of entry.

It is entirely up to you on how much information and parameters to put in the shortlist, but it is important to keep it updated. You could pluck off the figures from Google or Yahoo finance for a first glance, and if you want to go deeper, read them off the last quarterly or annual report available from the companies’ websites.

Such a shortlist serves as a useful quick reference in a sale period, so that you could make a fast decision of whether to buy in or not.

1 – The Bedokian Portfolio, p94-95

A Must-Read Investment Book

When it comes to the realm of investment books, there are tons of them. Some are written by famous greats, like Benjamin Graham’s The Intelligent Investor and Peter Lynch’s One Up On Wall Street. There are also books on the different portfolio styles, like The Permanent Portfolio by Craig Rowland and J.M. Lawson, Pioneering Portfolio Management by David E. Swensen, and not forgetting my humble contribution in the form of The Bedokian Portfolio.

There is another investment book which I felt is a must-read by both beginners (for learning) and seasoned investors (for re-learning), and it is Essentials of Investments. It is written by finance professors Zvi Bodie, Alex Kane and Alan J. Marcus.

Hold On, Is This a Textbook?

Well, yes it is, and it is about 700-plus pages thick.

A school textbook usually provides the basics of a subject in a structured, topical manner, along with worked examples, problem questions and a few real-life articles pertaining to the topics covered. Essentials of Investments is just that, as it covers almost everything you need to know about investing (and trading), plus the whats, whys and hows. It talks about equities, bonds, portfolios, options, futures, basic economics, financial statements, etc. Now you know why the book is that thick.

But 700+ Pages, It May Take Too Long To Read

In my opinion, if a reader has the drive, focus and passion, no measurement of book thickness is able to stop him/her (Harry Potter book fans are a good example). Granted, however, that the mathematics and formulae inside may be a bit daunting and dry to some, but you could casually read through at your own leisure or you could just jump around the chapters; After all your time limit is not one semester.

I personally feel the key takeaways in terms of additional knowledge gained are priceless and can open additional doors in your investment journey.

Happy reading!

You can purchase Essentials of Investments from bookstores such as Amazon and Books Kinokuniya, or borrow it from the public and institutional libraries (use the respective library portals to search for it). Currently it is at the tenth edition, but you could still read up the previous editions.

Yield on Cost

We all know that by normal convention, yield is calculated as the annual dividend/coupon/interest amount divided by the current price of the security, which is current yield. However, some investors, instead of using current price, used the entry price as the denominator. This is also known as yield on cost. They would prefer to look at this version of yield as they wanted to know the returns based on their initial investment amount.

For example, a person bought Company A’s shares at $1.00 a few years ago. Fast forward to the present day, the share price had risen to $1.50.  If the current year dividend was $0.15, the “normal convention” would be $0.15/$1.50 = 10%, but to him/her who uses yield on cost, it would be $0.15/$1.00 = 15%.

Do note that for yield on cost, we would have to take in two major considerations. The first would be the inflation effect. Assuming he/she bought the shares at $1.00 each back in end 2010, and with a 3% annual inflation rate, the new cost at the end of 2016 (for six years) would be about $1.19. Using the above example, the yield would actually be $0.15/$1.19 = 12.6%.

The second major consideration would be the factor of capital gain/loss. What if the share price dropped to $0.80 and the dividend is at $0.20? It would be $0.20/$1.00 = 20% for him/her, which looks good, but (not taking inflation into play here) there is a capital loss of $0.20. Of course, any investor would have noticed it, but if one concentrates on this yield only, the capital loss would be like the elephant in the room that was not addressed.

Whether an investor wants to look at current yield or yield on cost, it is entirely up to his/her preference.

Before You Jump In, Some Admin Stuff To Look Into

It felt good being a first time investor; after reading The Bedokian Portfolio or some other investment books or material, you will feel the urge to jump straight into the action. You may quickly want to open up a brokerage and/or regular savings plan account, start to look for securities to invest in, and voila, you have started an investment portfolio.

Then as the months or years gone by, suddenly you have discovered something; your Company A and REIT Z shares are straddled between your Central Depository (CDP) and your regular savings plan accounts. Your Corporate Bond Q is split between a custodian brokerage and a bond fund brokerage account. If you want to sell say, Company A shares, you may have to incur twice the transaction costs because they are placed in different platforms. Ditto for buying with the added headache of choosing which platform to buy.

Just as you had taken the time to learn about investing, you should also take the time to do some research into how to go about it. Administrative matters, though they are trivial, must be aligned with your overall investment strategy. They will sometimes give you the greatest headache if things are not falling into place.

Brokerages and Trading Platforms

A few fellow investors and traders I spoke to placed commission charges as the top priority. While this is correct as such transaction costs erode our returns, we have to consider other factors in place, such as where the securities are being kept (CDP or custodian), further charges like custodial and dividend handling fees, and the value added features, e.g., reports, videos, etc. in the trading platforms.

For myself, I use CDP-linked brokerages for local individual securities (equities, REITs and bonds), and a custodian brokerage for foreign securities and exchange-traded funds (both local and foreign). The main reason why my securities are with CDP is to have more control when corporate actions occur, like rights issue, attendance of annual general meetings, etc.

Regular Savings Plan

Firstly I would like to declare that I do not have any regular savings plan (RSP) in place. I had mentioned in my ebook that it is preferred to have your holdings in a good-to-look number to facilitate ease of transaction during rebalancing¹. Since RSP uses dollar-cost averaging in the form of a fixed dollar amount per month, the chance of having odd-lots (number of shares not in multiples of 100s for locally-listed shares) is very high.

That being said, I am not against RSPs. In fact, I have thought of a way to incorporate RSPs into your regular Bedokian Portfolio. Remember the core-satellite approach?² For RSPs, it is better to use them to purchase ETFs for your core, since the core would be rarely touched during rebalancing. You could also view your holdings in the RSP as the “inner core”, with ETFs bought using usual brokerage means as the “outer core”, so in case that the rebalancing reaches the core, the outer ones would be transacted first.

One More Thing

The last part of the admin of your portfolio management would be the securities themselves. If you have bought Company A shares from a brokerage using CDP as custodian, then any further purchase of the shares must be bought using this same channel. This is to prevent additional transaction costs incurred as stated above, and also an accidental short sell. The latter could happen if you cannot recall the quantum of shares allocated between the types of custodian and unintentionally oversold.

As for ETFs, following the RSP section recommendation, you could use RSP to buy in regularly for the inner core, and select one form of custodial arrangement for the outer core.

1 – The Bedokian Portfolio, p77-79

2 – ibid, p122-123

Further references

The Bedokian Portfolio, Chapter 2 – The Workings

Seeing Red?

Just last month, I had written about bull market investment strategies, and within the past week, we had seen some red. No doubt red is good for the upcoming Lunar New Year festivities, but seeing this colour in the markets is a real bummer. Ah, such is the roller coaster nature of the financial markets.

I have been hearing from some sources, online and in person, that the bear is going to come, and along with it some panic and a possible trip to a reservoir that bore my namesake. First things first, let us all calm down.

Is this going to be just a correction? Is this going to be the beginning of something worse? Is this going to be the next GFC?

Well, I don’t know.

But, as investors, particularly the Bedokian Portfolio ones, we must be prepared. Again, if you are in the passive side, just wait for your next rebalancing cycle and reallocate accordingly, and move on. If you are in the active side, there are a few strategies to adhere to, like the 10-30 Rule¹, look out for bargains in fundamentally strong equity/REIT counters that fall for no reason, or consider other asset classes.

Remember, investing is a long journey that goes uphill and down.

1 – The Bedokian Portfolio, p119-120