What Causes Similar Risk Bonds to Earn Rates Below the Coupon Interest Rate?
- The coupon rate of a bond and its effective annual interest rate, also referred to as yield, will be equal only if the bond is bought at face value. As the price deviates from the face value, yield and price move in opposite directions. For instance, a bond with a face value of $1,000 and 10 percent coupon will pay $100 in interest every year. The holders of such a bond are also entitled to full repayment of the face value upon maturity. If, however, you buy this bond for $500, the annual interest payment will equal 20 percent of your initial investment. The lower the price, the higher the effective interest rate. As a general rule, bonds with similar risk profiles should have similar effective interest rates, also known as yields. However, various other factors also influence the yield of a bond.
- A critical factor in bond pricing is liquidity. A liquid bond can be sold quickly at almost any time before its maturity. Therefore, the buyer does not have to wait until the expiration date to recoup his investment. An illiquid bond, on the other hand, is hard to sell as few investors are interested in it. This can be due to a lack of reliable information about the issuing firm, few bonds changing hands on a regular basis and the resulting lack of trading history or various other reasons. Liquid bonds are more attractive to investors as they provide a great deal of flexibility, whereas investing in an illiquid bond might mean having to wait several years before the buyer has a chance to unwind the original investment. Therefore liquid bonds trade at higher prices and consequently lower yields than illiquid ones.
- When investors analyze the probability of losing money from a bond investment, they consider the default risk as well as the recovery rate in case of a default. The default risk refers to the probability that the issuer will fail to honor interest and/or principal payments. If this happens, legal proceedings will ensue and bondholders will attempt to recover at least some of what they are owed. The percentage of the original investment that bondholders expect to recover after legal proceedings is referred to as the recovery ratio. Two bonds that carry the same default risk may trade at different yields if their expected recovery ratios differ vastly. As investors would gravitate toward the bond with a better recovery ratio, such bonds would trade at a higher price and therefore lower yield.
- Another reason certain bonds may yield less than others despite having a similar risk profile is their convertibility. Some bonds can be converted into common shares of the issuer at any point before expiration. This conversion is a right but not an obligation and is therefore a valuable feature. Convertible bonds trade at lower yield than their non-convertible counterparts, since bondholders love to have the ability to benefit from upside swings in stock prices. In extreme cases, in which the stock price is expected to advance rapidly, convertible bonds can even carry zero percent interest rates.