We have written often about bonds and, also about preferred stocks as conservative income-generating investments. Many investors will want to have some money committed to either or both of these vehicles.
When considering any fixed-income type investment, of course, one of the main considerations is the return expected from it. The net returns on these investments come primarily from the cash flow in the form of interest (on bonds) or dividends (on preferred stocks). But this is not the only component of the return, and sometimes not even the most important one.
This is true because the income on fixed-income investments is, well, fixed – but the price of the instrument is not.
The prices of preferred stocks and bonds fluctuate, primarily in response to changes in the interest-rate environment. An older bond that pays 8% in an environment where competitive newly-issued bonds pay only 5%, is paying $30 per year per thousand-dollar bond more than its peers. That older bond will be valued more highly. It will be quoted at a premium to its face value.
Most often as individual investors we will not be buying bonds or preferred stocks directly from the issuers. We will be buying them through stockbrokers in what is called the secondary market. The bonds and preferreds that we buy will have been issued some time ago, maybe many years ago, when interest rates were much different. The prices that we pay today will seldom be equal to the original face amount.
Because of this, there are actually four different measures of yield that we must understand. Fortunately, it’s not difficult. The four measures are:
Here is a simple example, from a broker’s bond listing:
Corporate Office Properties 5.25% bonds due 2/15/2024. Callable on or after 11/1/2023.