Say I want to buy a bond that matures in 10 years, and that pays out 5% of once a year, so it has 10 payouts remaining. Say the value is 100$. Say the bond is being sold for 140$ today. I would be paid a total of 150$ (10x 5% + the 100), and put in 140$. This means that over the course of 10 years I make 10$ on an investment of 140$, which equates an annual rate of 0.69%. This is clearly terrible. Yet most of the actual bonds I can buy at my broker lead to these kinds of figures. Why would anyone buy these products given the extremely bad returns?
You cannot add together payments made at different times. The actual interest rate implied by the transaction you describe:
- pay out $140;
- receive 10 annual payments of $5, first payment a year in the future;
- receive a "balloon" payment of $100 at the time of the 10th annual payment;
is 0.818% compounded annually. (Find a mortgage calculator that includes a balloon payment at the end of the term)
That said, the reason the bond is priced at $140 is that other purchasers believe that a 0.818% return on their investment, bad as it appears, is a good deal at the moment, given the stability and history of the bond issuer, and interest rates available from similar investments (savings accounts, CDs, money market funds...)
Here is a current Treasury Bond example:
Redemption date, 2/15/2029
Current yield, 2.678%
Bond price, 122.625
If I were to calculate the bond price nominally, that would be 5.25/.02678 = 196.04 . So additional bond pricing is necessary to allow for approaching redemption. That's approximately ((5.25 - 2.678) * 10 years) + 100 = 125.70.
I couldn't use the given example but the obvious answer to the question is to buy a bond when it is correctly priced.