Bonds — Bond Analysis — Science or Numerology?

Part II — EVALUATING BENEFITS

In Part I, we examined some of the risks associated with bond investing. Here we'll look more quantitatively at evaluating the potential rewards.

One of the most common and obviously useful quantitative techniques is yield calculations.

Calculating Yields

The simplest yield calculation is the current yield. Simply, divide the annual coupon amount paid by the current price. For example, a $1000 bond with a 7% coupon currently selling at $950, has a current yield of:

CY = [($1000 x .07)/950] = 70/950 = .0737 = 7.37%.

A mathematically more complex, but more common and useful yield is the YTM, Yield To Maturity. The formula is daunting, but essentially involves including capital gain (or loss) and accounting for the (fractional number of) years remaining until the bond matures. The YTM for the above example is: 8.53%, which represents the return on the bond purchased today at discount and held to maturity.

Other forms and calculations are even more mathematically involved, including Duration (or Macaulay Duration), Convexity and others. All are variations on the same theme. Make assumptions about changes in rates and prices over the next X years, throw in the known coupon, face value and maturity of the given bond, and turn the crank.

Fortunately the investor less interested in elegant formulae and more in profit, needn't forgo bond investing since calculators are readily available to make these estimates easy. Charts and dynamic tools to compare yields among different instruments, based on differing assumptions, are also easy to find.

Yield Curve

Use of these tools makes possible the creation of one of the more useful graphs called the Yield Curve. Essentially a graph of Yield (plotted vertically) vs Maturity (the horizontal axis), it allows the comparison of different yields for different length bonds. The normal yield curve tends to rise gently, tapering off to a flat line. A steeper rise taking longer to flatten is called a steep yield curve.

When rates are higher on short-term bonds than long-term, the curve becomes what's called 'inverted', producing a graph somewhat bowl shaped. This represents a relatively unusual situation, since predictions are, in general, less certain the longer the time horizon and the more investors have to be compensated for the increased risk by higher rates.

What causes the inversion? Usually the result of political trends, investors may settle for lower yields now when rates are expected to be even lower in the future. I.e. Investors are projecting an opportunity to lock in rates before the bottom falls out.

Naturally the specific shape of the curve changes over time.

Just as one example of its usefulness:

Typically, 30-year Treasuries yield three percentage points more than three-month Treasury bills. If the spread increases, the slope of the yield curve increases drastically. Long-term bond holders are signaling their view that the economy will improve quickly in the future.

Add it to your quantitative toolbox, but remember that no single indicator tells the whole story. Acquire as much information as you have time to analyze and study it until you understand the implications.

Also remember that bonds, from the perspective of the average investor, are intended to be much longer-time frame investments. Today even the short 13-week Treasury is long relative to many stock investments. Be prepared to weather the ups and downs, while keeping an eye on developments. Rarely do long term trends change significantly in a day.

Rather than good luck, think 'good planning'. And, incidentally, good luck.

As your knowledge about bond analysis continues to grow, you will begin to see how bond analysis fits into the overall scheme of things. Knowing how something relates to the rest of the world is important too.

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