Wednesday, September 17, 2014

Cheat sheet of bond yield, bond price, and interest rate

1. Bond price vs bond yield

Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.

Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

2. Bond price vs. interest rate

An easy way to grasp why bond prices move opposite to interest rates is to consider zero-coupon bonds, which don't pay coupons but derive their value from the difference between the purchase price and the par value paid at maturity.

For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of return at the present time is approximately 5.26% ((1000-950) / 950 = 5.26%).

For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his or her satisfaction with this return depends on what else is happening in the bond market. Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn't be in demand at all. Who wants a 5.26% yield when they can get 10%? To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield).

1) Bond basics: yield, price, and other confusion

Real estate investment vs. dividend stock investment

Both RE and dividend investments are good tools to accumulate passive income and asset appreciation.   They are both my favorite investment tools.

Both of them offer stable passive monthly income.  Stock passive income is achieved by monthly or quarterly dividend income; RE one is through monthly rental.

Both of them provide very good asset/principle appreciation potential.  Stock investment is via the invested company value upward potential, while RE investment is through house/land value appreciation.

Since both of them are doing well in asset appreciation, they are both excellent choices to hedge against inflation.  We expect inflation will shoot up high in the near future, so to adopt some proactive approaches are absolutely necessary. 

Some people prefer dividend income to rental income because: 1)  RE investment requires big amount of money up front for the down payment.  Usually down payment is 20-25% of the purchase price.  If the house is bought at $30K, down payment will be $6K, additional costs include closing cost, insurance, tax, and sometimes HOA. 2) Another obvious reason hindering most investors from RE investment is because it requires dealing with tenants.  No one likes to be bothered by a mid-night phone call from tenant to report a broken toilet.

These disadvantages aside, I prefer RE investment to dividend investment with the main reason of leverage

1) Real estate is a few places that you can only pay a fraction (around 20%) of the purchasing prices to get a house.  By using financing from banks, you can buy more properties, which will produce you much higher income than you could by paying in all cash. For example, if you had $150,000 to invest, you could buy a duplex for all cash (no loan) that produces $12,000 a year in income.  However, if you take the same $150,000 and use leverage, you can buy property valued at as much as $750,000.  If the bigger property generates $6,000 a month in income and you subtract the loan payment of $4,000, you would make $2,000 a month.  That is double what you would have made without using financing.

2) Another beauty of RE investment is, besides time value same as in stock investment, mortgage principle is paid quietly without consideration in regular ROI calculation.  For example, if a house's value is $300K.  You pay the down payment $60K and other fees $5K, with the total out of pocket money at $65K.  Let's say the house is rented out, and after deducting monthly mortgage, insurance, and tax, the monthly net return is $300.  The return rate is usually calculated to be 5.5% (=($300 x 12) / $65K).  However, from the first monthly payment, mortgage principle is paid around $300 (increasing monthly), which isn't included in the calculation.  If the amount is included, the actual return rate will be double at 11%.