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Discussion Starter · #1 ·
Bonds have a certain yield determined at the time you buy a new bond. The expected yield is usually greater than the interest rate at that time.
If the interest rate goes up, the bond is not as attractive to buyers, because new bonds will give better yields to compete with the higher interest rates.
If the bond has gone part way to maturity, some coupons have been paid and so the yield is reduced, causing the price to be "discounted".

To all these - in simple form - yes or no?
 

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Bonds have a certain yield determined at the time you buy a new bond. The expected yield is usually greater than the interest rate at that time.
No. If the 10 year interest rate is 5% and a new 10 year bond is issued with a 5% interest rate, the yield will be 5% consisting only of the interest. The interest rate and yield are the same.


If the interest rate goes up, the bond is not as attractive to buyers, because new bonds will give better yields to compete with the higher interest rates.
Yes. So the bond's price will drop until its yield matches the new, higher interest rate. Otherwise who would buy your 5% bond when a new bond pays a higher interest rate. Then its new yield will be a combination of its interest payments and a capital gain. Assuming no further interest rate changes, its price will gradually rise to its par value at maturity. This is known as a discount bond.

The opposite is true for most bonds since interest rates have been dropping for a couple of decades. If interest rates drop, then the price of the bond will go up, so the new yield, which is the combination of its interest payment and price drop (capital loss) is equivalent to the new lower interest rate. Its price will gradually drop to its par value at maturity. This is known as a premium bond.

If the bond has gone part way to maturity, some coupons have been paid and so the yield is reduced, causing the price to be "discounted".
No. If the 10 year $1000 bond is issued with a 5% interest rate, and the 10 year interest rate stays at that level until the bond matures, then the price will not change from par value, and the yield will always be 5%. The bond's price will only change if the interest rate changes, as described above. The yield fluctuates inversely to price changes. The investor gets the interest (usually paid semi-annually for most bonds), then gets back the $1000 when the bond matures.

Remember when looking at quoted bond yield, it is the combination of the interest it pays (aka Coupon), plus any capital gain or loss between purchase date and maturity (when it returns to its par value).

You could probably find a better explanation somewhere like Investopedia.
 

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Discussion Starter · #5 ·
Remember when looking at quoted bond yield, it is the combination of the interest it pays (aka Coupon), plus any capital gain or loss between purchase date and maturity (when it returns to its par value).
Ah, that's the way it works...a combination. That you.

The investor gets the interest (usually paid semi-annually for most bonds), then gets back the $1000 when the bond matures.
But ....if the bond is sold just after the interest is paid, the yield to the buyer is halved, isn't it? The buyer has paid less than the original price, and gotten the same yield. Who gets the principal??
 

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But ....if the bond is sold just after the interest is paid, the yield to the buyer is halved, isn't it? The buyer has paid less than the original price, and gotten the same yield. Who gets the principal??
I left that part out for simplicity. Say the bond pays interest semi-annually. If the bond gets sold half-way between interest payments, then half of an interest payment has already accrued when ownership is transferred. So the seller would be credited half an interest payment, which would be debited to the buyer (because they will get the full interest payment when it is issued). Any time a bond is sold between interest payments, the prorated amount of accrued interest gets credited to the seller and debited to the buyer. In the broker buy screen there will be a field for the amount of accrued interest.

It's a bit like selling a house. A prorated portion of any tax and utility payments get settled between the seller and buyer when the final amount owing is calculated.
 

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Some people prefer discount bonds for their eventual capital gain at maturity, and others prefer premium bonds for the higher cash flow and don't worry about the loss at maturity. Attraction is different for different buyers.

ltr.
In a non-registered account, a discount bond is better since interest is taxed at a higher rate than cap gains.

In a registered account, one generally wants a premium bond because premium bonds are not as attractive to a buyer as is a discount bond. I bought a Telus bond in my RRSP a few years back at $137 because coupon yield was high and I got a better YTM than I would have for an equivalent bond priced at par or at a discount. It looks more shitty each year (capital loss) as market value declines towards $100 at maturity, but in reality my overall return will have provided me with a premium.
 

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But ....if the bond is sold just after the interest is paid, the yield to the buyer is halved, isn't it? The buyer has paid less than the original price, and gotten the same yield. Who gets the principal??
The price I pay for a bond reflects what the borrower has promised to pay me in the future. So, the price today reflects the coupon interest that will be paid at the next coupon date, and every coupon date thereafter, plus the principal and final coupon interest at the maturity. The value of each of those payments is dependent on how much they are paying on each coupon payment date, the amount of time I need to wait for it, and the risk they don't pay. We use the market rate for each time span, adjust for risk and discount the cashflow to today. Add up the discounted cashflows and we have the value of the bond today (ie the price).

For example, if we have a bond with 2 years remaining, 2% interest paid semi-annually, then the future cash flows per $100 are: 6months $1, 12months $1, 1.5yrs $1, 2 yrs $1 + $100 (for the principal). Total cashflows are $104. The value today, price you should pay, is determined by taking $1 and discounting with 6months rate, $1 discounted at 12months rate, $1 discounted at 1.5yrs rate, and $101 discounted at 2 yrs rate. Add up those 4 discounted amounts and we have a price. For clarity, four different rates are referenced (from different points in the future out the yield curve) to arrive at a determination of the price you should be prepared to pay for the bond. This is all computerized of course.

As explained above If one buys a bond between coupon dates the buyer will receive the entire coupon on the next payment date even though they didn't earn. So accrued interest is calculated and added to the price on settlement date. Accrued interest payment is Coupon amount x days since last coupon/days between coupon payments.
 

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In a non-registered account, a discount bond is better since interest is taxed at a higher rate than cap gains.
Yeah, these are pretty nice in non registered accounts.

Here's a recent example of one I bought. Of the 1.8% yield to maturity, 1.1% is the coupon and the other 0.7% is a capital gain. Another thing I like about these discount bonds with the lump sum capital gain (in the future) is that it's easier to do some tax planning around those CGs, for example with other tax loss selling, or using a carry forward loss.

What many people forget is that with bonds, the price also pretty much reaches par the year before it expires. So this gives you additional flexibility on the CGs from the discount bond. If there's an advantage for my taxes, I can sell it the year before it matures and pretty much get the same CG.
 
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