Continuing on with the series to help explain financial terms in ways that are hopefully more understandable, this post will deal with bond yields. (See the earlier post on – What is a bond?)
As the National Football League (NFL) is ending summer training for their season opener in early September, we will begin this conversation speaking about football teams. Even before the season begins, most experts and fans already have their predictions on who are the best and worst teams in the league. Even though I believe (due to the fact that I am a diehard Jet fan) that the New York Jets should be the ultimate favorite to win the Super Bowl this year, most of the experts disagree and have decided the race will be between Green Bay Packers and Houston Texans. On the other side of the equation, most agree that the Cleveland Browns will struggle to win six of their 18 games this year.
So it is with a companies’ financial future and their ability to repay the money lent to them as a bond. The marketplace has opinions about the future prospects of the company as well,and thus the companies’ ability to re-pay the loan and the promised interest on a timely basis. In both circumstances, these perceptions guide how individuals would invest their money. As participants in the marketplace view certain teams or companies stronger than others, they will have stronger odds and thus the companies will not have to pay as much interest as the longshot. For the NFL, these bets are only legal in Las Vegas (but do not tell that to the hundreds of participants in company polls).
In the corporate bond market – where companies come to borrow money from investors, those companies that are perceived to be more like this year’s Cleveland Browns will be required to pay a higher percent than those companies perceived to be stronger like this year’s Green Bay Packers. This translates to a higher bond yield or what ultimately should be paid back to the person or corporation who lent money to the company. A bond with a high interest rate usually has a higher yield than one with a lower interest rate.
Just as the perceived quality of the football teams changes every year, so does the perception of the corporate financial landscape change as well, but on a minute to minute basis. Therefore, once the bond is issued with a set interest rate, the market deals with that changing perception by either selling the bond at a premium (worth more than its face value) or at a discount (less than its face value). The fluctuating bond prices manipulate the interest rate received or the overall yield to the investor.
Other factors would determine the bond’s yield as well. The longer until the bond needs to be repaid or its maturity, the more sensitive it is to changes in general interest rates. The analogy that is usually given is one of a seesaw. On one side of the seesaw are the interest rates and on the other side is the bond maturity or how long until the bond needs to be repaid. Those bonds with longer maturity are at the end of the seesaw and the ones that have a shorter maturity are closer to the fulcrum and thus do not rise and fall as much with interest rate movements up and down.
The perceived quality of a bond issuer usually corresponds to the rate of return on the bond. High yield bonds are usually riskier than those with lower yields. So if the Cleveland Browns were a corporate bond they would need to pay a higher rate of interest this year due to their perceived lack of success. So be careful of being told the Cleveland Browns have as much chance of winning the Super Bowl this year as do the Green Bay Packers.
Remember: there is no free lunch in finances. Higher yield equals higher risk regardless of the sales pitch.