Securities For Beginners

Thursday, December 22, 2005

InvestorGeeks.com on Bonds

This week Chris posted a nice article on bonds on InvestorGeeks. In my opinion, no investor should exclude bonds from his portfolio, because they are a secure way to create a regular income stream. Well, actually it isn't completely safe, as the Argentinian bonds showed in the past. But since rating agencies like Standard & Poor's publish bond ratings the risk can be seen as easily comprehensible compared to stocks - as long as you stay informed.

Chris mentions the yield to maturity formula to calculate a bond's actual rate of return. This formula gives you the exact rate of return but is very complicated. A less complicated formula is:

r = (c*B + (B-P)/n) / P

with

c = coupon rate
B = par value
P = purchase price
n = years to maturity

Note: This formula is less exact than the YTM formula, but it gives you a basic idea on the bond's rate of return. The actual YTM is below the above formula's result. Let's compare them with an example:

c = 6%
B = $1000
P = $980
n = 8 years

Simple formula: r = 0.0638 = 6.38%
Exact YTM: r = 0.0633 = 6.33%

You see: There is a little difference, but you get a first impression on the bond's rate of return.

Links:

Moneychimp: YTM
Fool.com: Investing basics: Bonds

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