Effective Yield

Fundamentals of Market Investing by Adam J. McKee

Most of us think of bonds as Mr. Buffett thinks of companies.  You buy them and then hold them.  They are not for trading; they are for growing in value over time.  On Wall Street, this is not the case.  There is a lively market in bonds, and they are frequently traded.  Traders try to outguess each other as to what macroeconomic factors will do to bond prices, and the winners can make substantial profits.  All of this trading means that the face value of the bond may change up or down until maturity.  This gives bond funds the opportunity to buy bonds at a discount at times.  If this happens, the gain from the discount and the interest payments are both profitable, and thus you get a higher profit that you thought you would.

When you are invested in a security for income, don’t pay too much attention to the face value of the instrument.  If you compare face value growth to stocks, for example, income investments will always come up short.  When you reinvest your income from your shares of the fund back into the fund, the bulk of your gains are in the form of increased shares rather than increased share prices.  This sort of growth happens quarterly or yearly, not every minute of every day as with stocks.  If price changes do worry you, make sure that it is because of macroeconomic forces that you believe are a trend.  Short-term volatility should not keep you up at night.

Par Value

When a bond is issued, the issuer establishes a face value.  Traders call this the par value of the bond.  As economic conditions change, traders will buy and sell bonds at a discount to the par value or at a premium to the par value.  At maturity, the bond is traded in for cash at this par value, and traders that have not made a profit by that time are out of luck.  These up and down movements do not affect investors that buy and hold bonds to maturity, but there is an opportunity cost associated with buying low-interest bonds and holding them when rates rise.  These movements do affect the face values of bond funds because the paper losses are reflected in the share price of the fund.

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