Why would I buy bonds?

Question

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?

Answer 1

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...)

Answer 2

Here is a current Treasury Bond example:

Redemption date, 2/15/2029

Coupon, 5.25%

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.