Editor’s Note: Few things can kill a cocktail conversation like bond talk — and we are obviously not talking about the kind of bond preceded by “James.” Not only do most people think bonds are boring, they also find them incredibly confusing. If you want to be a smart investor, though, you should know where your money is going — and that includes understanding bonds and their most complex feature, pricing.

This week, MintLife presents the third article in our Investing 101 series, provided by Minyanville.com.

A bond is referred to as a debt instrument. The corporation or government issuing the bond promises to repay the full value of the bond, or par value, with interest and by a specific due date.

A 3% bond with a par value of $1,000 is a contract between the issuer and the bondholder, where the issuer pays annual interest of $30, or 3% of the par value. On maturity date, the par value of $1,000 is repaid.

Because bond interest rates are fixed, but market rates are constantly changing, bond values also change all the time. When interest rates are higher than that offered by a bond, that bond becomes less desirable. As a result, that bond will be worth less than its par value and sell at a discount.

If market rates fall below the bond’s fixed rate, the bond becomes more attractive and it starts selling at a premium.

For example, when a bond is at 102, it is worth $1,020, or 2% above par value. If a bond is at 97, it has been discounted to 3% below par value.

The changes also affect the yield on the bond.

No matter what its current market value, the bond always pays the same interest. A 3%, a $1,000 bond pays $30 per year:

Interest rate x par value – Interest (3% x $1,000 = $30)

This so-called nominal yield is also calculated by dividing the interest paid per year by par value:

Interest ÷ Par Value = Interest rate ($30 ÷ $1,000 = 3%)

If a bond is selling at a premium or discount, however, the current yield on that bond is going to be different.

For example, when that $1,000 par value is worth 102, or $1,020, the current yield is reduced:

$30 ÷ $1,020 = 2.9%

This is only a slight difference; but for institutional investors relying on bond yields for millions of dollars, it adds up to a lot of money.

If the bond is selling at a discount, on the other hand, the current interest rate is higher. For example, if a bond with par value of $1,000 is at 97, the calculation for current yield is:

$30 ÷ $970 = 3.1%

No matter how much a bond’s current value changes, at maturity the par value ($1,000 in these examples) is always paid. If you purchase individual bonds with the idea to hold them to maturity, in other words, you could only take into consideration the bond’s nominal yield.

But things get more complicated if you purchase bonds on the secondary market, at a premium or a discount. In those cases, a more complex calculation of yield to maturity comes into play, including a combination of interest plus the net discount or minus the net premium. The adjustment is spread over the time remaining to maturity. So an investor buying a bond at premium or discount has to be concerned with three different versions of yield: Current yield, nominal yield, and yield to maturity.

Because debt investments are complex and contain a range of risks, most new investors will opt for money market or income mutual funds. In that way, they rely on professional management to pick bonds and other debts to include in a diversified portfolio.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes fulltime.

Investing 101: How Bonds Are Priced was provided by Minyanville.com.

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