What can yield to maturity, duration, and credit ratings tell you about a bond?
Yield to maturity
There are a few numbers to look at when evaluating a bond. The first is its yield to maturity, or YTM. That gives you the annual yield on the bond, relative to its trading price, if you held it all the way to maturity – imagining that all its interest payments were reinvested (as investors often do) back into the bond at the same yield.
YTM is often thought to be more useful than looking at just coupon value or yield, since it takes into account any gains (or losses) you might make from buying a bond below (or above) par value.
But because it assumes reinvestment, it doesn’t give you the full picture of what the bond might be worth: if yields continuously fall while you own the bond, they won’t compound as effectively, and your return might be lower than YTM suggests. 😢
The other big number to assess is duration – which measures a bond’s price sensitivity to interest rate changes. Duration is a “weighted average” of the time you need to wait for both the payment of coupons and the return of your original investment and is therefore linked to – but distinct from – maturity.
The longer a bond’s duration, the more coupons remain to be paid. The higher that figure – and therefore, the more exposed the bond is to interest rate changes over time – the more its price will fall as rates rise (or rise as interest rates fall).
Generally speaking, for every 1% change in interest rates, a bond’s price shifts around 1% in the opposite direction per year of duration. 🔄
You should also look at the credit rating of the government issuing the bond. That’s less of a risk with big economies like the US, UK, or Germany, but if you’re investing in more exotic locales, you need to be aware of the likelihood of getting your money back. 😨
That’s particularly true of emerging markets – which, as we’ll see in the next chapter, is one popular area for investment in government bonds. Argentina 🇦🇷 for example, has defaulted eight times in the past 200 years. The ratings are put together by agencies, all of whom use different scales – you can find them here.
When you’re looking to invest in a bond fund or ETF, rather than individual bonds – more on that later, too – you’ll see the credit rating presented as an average of everything in the fund’s portfolio. That means it’s liable to change over time as the fund’s holdings change, and depending on how it’s calculated, it may not give you a full idea of the fund’s profile. 🤨
Yield to maturity, duration, and credit rating are three key things to consider when evaluating a bond. Now you know what to look for when analysing a bond, it’s time to figure out how to actually build a bond portfolio.
Keep in mind that when you invest, your capital is at risk.