The bond market is massive, bigger than the stock market. Meaning there is endless opportunity to make a living and even passive income from bond yields. There are different strategies one could implement and we are going to explore passive income through bond yields today.
What are bond yields and yield definition?
First, we should explore bond yields and the yield definition. Yield is the generation of earnings realized on an investment over a set time period. It is a percentage based on the invested amount, the current value, or the face value of the security in question. We can include the interest earnings or the dividends received for a particular security. There is a misconception with higher yields, that they are generally a positive outcome. In the case of high dividends offered by a company, they may not always be the best. Companies usually offer higher dividends because their stock price is falling and set to continue down that path. However higher yields are also correlated to lower risk and higher income.
In our case, we want to understand the yields on bond security and how we can take advantage of that for passive income. The bond yield is paid annually or semi-annually as interest and it is very easy to calculate. What we call the nominal yield.
Nominal Yield= (Annual Interest Earned/ Face Value of Bond)
Let’s look at an example. If you have a bond with a Face Value of $100,000 that is set to mature in 1-years time and it pays 4.5% annual interest. The yield is calculated as ($4,500/$100,00) =4.5%.
There are bonds that have floating interest rates, meaning their interest payments vary over the lifespan of the bond and you will have to calculate the yield based on applicable interest rates at different terms.
A bond’s coupon rate or interest rate stays the same since the inception of the bond. What changes is the interest rate in the market, the higher the coupon rate the better for the value of the bonds in a low rate environment? If the coupon rate is 5% on the inception of the bond and the market rates drop down to 2%, this bond has just gained value. This is because that bond can now earn the holder a much higher rate than what is offered in the markets.
However if the coupon rate is 5% and the market rate is now 6%, that bond loses value. That is because now issuers can issue bonds that will offer 6% which is more attractive to buyers.
Yield to Maturity
The yield to maturity is a measure of the total return expected on a bond every year if the bond is held to maturity. This is a different measure than the nominal yield. The nominal yield is calculated once a year and can change each passing year. The yield to maturity is the average yield expected each year and the value is expected to remain constant throughout the whole time the bond is held, assuming to maturity of the bond.
Yield to maturity formula
The yield to maturity formula is a little more complex than the yield calculation. The yield to maturity is equal to:
C= Coupon/ Interest Payment
F= Face Value
n= years to maturity
Bond strategy for passive income
Bonds are a pivotal part of any portfolio for diversification. Typically bonds rally when the stock market dips in value. However, no matter what the bond will pay you interest either once a year or twice a year if the coupon is based on a semi-annual rate. The passive income strategy is simple in theory, but should also consider the value of the bond by maturity.
This involves a bond ladder approach. The bond ladder approach, in the simplest terms, is a bond portfolio with different maturities. To create the ladder, one bond expires at a time rather than all at the same time. The bond ladder reduces the reinvestment risk associated with rolling over bonds when they mature. Assume your portfolio has $100,000 to invest into your bond portfolio you could break it into 10 different bonds with a face value of $10,000 each. Each bond has a different maturity year.
The main reason for a bond ladder approach is to diversify the maturity of the bonds so you are not locked into a single duration. You can lock yourself in for a long period of time and that disables the ability to protect yourself in different bond market conditions. Assuming that full $100,000 was invested in a 20-year bond with a 5% coupon rate. This means that you can’t capitalize on the changing market conditions of increasing or decreasing rates.
By the end of your maturity, if the rate gets too extreme lows and your 5% bond is about to expire, you will not get the chance for a better rate and you will be stuck with low rates when you look to buy another bond. The bond ladder is meant to have a bond mature on a near yearly basis so you can navigate the market fluctuations.
The second pivotal aspect of the bond ladder is that you can stagger the coupon dates so that you can get passive income at any time. Instead of having annual income only from your annual bond interest rates, you can break the different bonds into monthly, semi-annually, quarterly, and annually, whichever you prefer. This is an important aspect of retired individuals.
In this scenario when Bond A expires, in 2-years you can reinvest the principal into another longer-term bond so the ladder continues.
Bonds are an amazing way to diversify your portfolio as well as create an amazing bond ladder that provides passive income. If you understand how to use the yields and diversify in different maturities to combat market conditions changing and changing rates you can develop a really good long term income strategy.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.