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How can a bond guarantee a 5.5% return rate?

I am not sure how this is possible. I see that Puerto Rico has a municipal bond that gives more than 5.5%. How secure are these AA bonds? Why other AA bonds are not giving that same return? What I am missing?

  • Actually, the effective rate is higher, as interest income from a Puerto Rican bond is exempt from Federal and State income tax! – duffbeer703 Nov 3 '11 at 18:33
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TL;DR: unless there are some special circumstances that you didn't specify in your question, that 5.5% is not anything like a guaranteed return.


Don't confuse the coupon rate with the return.

If the coupon rate is 5.5%, that means you'll get a $55 check every year for each $1000 bond you own. (Assuming they pay annually, for simplicity.)

However, it is unlikely that $1000 is the price that bond will fetch on the open market. If the US Government issued a bond with a 5.5% coupon, the market price would increase above $1000. Let's say you ended up having to pay $2000 for the bond. You'll still only get paid the same $55 interest, which means the yield on the bond you bought will be 2.75%. (Note that someone else might buy the same series of bond on the open market and pay a different price -- they'll have a different effective yield.)

If you hold the bond until maturity, and the issuer doesn't default, nothing really changes. But if prevailing interest rates change, then the market value of the bond changes. Say you need to sell the bond in two years -- prior to maturity. Assume rates have gone up, and you'll only be able to sell it for $1500. Your return on the investment in the bond is negative (the $110 in interest doesn't cover the drop in price of the bond). On the other hand, maybe rates drop and the price of the bond goes up to $2200. In this case, your return is your yield amplified by the rise in price of the bond: $110 plus the $200 gain, a 15% return over two years.

If the issuer defaults then your return may also be negative.

Complicating matters even further, if the bond is callable then the issuer may be able to prepay the principal prior to maturity. This could leave you with cash at a time when you can't invest the cash at favorable rates, which reduces your return.

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  • Great answer, what is TLDR? – JTP - Apologise to Monica Nov 3 '11 at 16:27
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    @JoeTaxpayer: TL;DR is "Too long, didn't read". Net-speak for "executive summary". – bstpierre Nov 3 '11 at 17:14
  • Better late than never: the example at the start of this answer is incorrect. If you buy a $1000, 5.5% bond for $2000, you will only get $55 a year in coupons, and the face value of the bond, $1000, at maturity. This could not possibly produce a return of 2.75%, or indeed any positive return at all... – DJohnM Aug 23 '14 at 1:37
  • @User58220: feel free to edit the answer with numbers that make sense. – bstpierre Aug 23 '14 at 2:24
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A bond offers a "coupon" at a FIXED rate for every $1,000 of investment. In this case, it would be $55 a year, or 5.5% a year. That rate is "guaranteed." (But the guarantee is only as good as the guarantor.)

Bonds are bought and sold in the market for amounts of AROUND $1,000. The $1,000 is represent by 100 (per cent), which is called PAR. If it is quoted for less, say 99 (multiply by 10 to get 990), it is selling at discount. Then the $55 coupon is MORE than 5.5% of the (discounted) $990 value. This is called your current yield. And your so-called yield to maturity is also MORE than 5.5% (because) you take a pro rata share of the discount each year in your yield calculation.)

If it is quoted for 101, or MORE than par, your $55 coupon (and corresponding yield to maturity is LESS than 5.5%

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A bond with a fixed return guarantees that return the same way that you guarantee a certain percentage when you buy a car from a dealer. It's just an agreement they are making with you.

Just as there is a possibility that you won't make your car payment, there is a possibility that bond issuers won't pay the return they promise. That's why the rating could be higher or lower.

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