Hello, Tigers!
In the last lesson, we focused on the definition and categorization of bonds and learned about the five basic elements of bonds. In this lesson, I'll take you through: why you should invest in US treasuries and the risks of investing.
In addition, I'll show you hands-on how to calculate the return on US treasuries.
I. Why invest in US treasuries
Many Tigers may say that the returns on US treasuries are so low compared to assets like stocks and options that they don't feel attractive.
It's certainly true that bonds seem less attractive when looking only at potential future returns. But from a long-term asset allocation and risk management perspective, the US treasuries offer three unique advantages:
Low entry barrier:
Unlike many other bond products that require a high starting investment, the threshold for purchasing bonds on the Tiger Trade App is very low.
Take US treasuries as an example, you can currently invest in treasuries on the Tiger Trade app with as little as $1,000. In addition, the trading process for purchasing treasuries is very simple, similar to purchasing stocks, and I will detail the trading steps in the last lesson.
Lower risk:
Compared to assets like stocks and options, bonds are low risk. If you're buying a bond with a sovereign backing like a US treasury, you're essentially not exposed to credit risk. After all, to date, there has never been a credit default on a US treasury.
Steady returns:
Bonds offer fixed interest payments. As long as you hold them, you receive interest payments regularly, unaffected by market fluctuations, providing relatively stable returns. Upon maturity, you also get your principal back, making them suitable for investors who prefer lower risk.
II. Two major risks of bond investment
Despite the fact that US treasuries are characterized by a low threshold, low risk and stable returns, there are still some potential risks. In addition to the exchange rate factor, investing in bonds will be exposed to two main types of risk: credit risk and interest rate risk.
Credit risk:
Credit risk refers to the risk that the bond issuer can't repay the principal or interest on time. Credit risk significantly impacts the bond's price and investment returns.
Generally, higher-rated bonds have lower yields, while lower-rated bonds offer higher yields.
Institutional investors like pension funds and insurance companies typically prefer higher-rated bonds as they prioritize capital and stable interest payments. Other institutional investors, like high-yield bond funds, might seek higher returns and be willing to take on more credit risk.
Interest rate risk:
Interest rate risk refers to the risk that bond prices might fluctuate due to market interest rate changes. Interest rate risk is one of the most significant risks in the bond market. But why do interest rates pose a risk to bonds? Here's an example:
Suppose you buy a $1,000 face value, 5% fixed-rate bond with a 10-year maturity, meaning the bond pays $50 in interest every year (5% * $1,000). However, after you purchase the bond, market interest rates rise from 5% to 6%.
In this scenario, your 5% bond becomes less attractive because newly issued bonds have higher yields. If you decide to sell your bond, its price might drop as other investors can opt for higher-yielding bonds. You may have to sell your bond for less than $1,000, incurring a capital loss.
Note that US treasuries generally only face interest rate risk, whereas corporate bonds and some municipal bonds can involve both interest rate risk and credit risk.
III. Earning from bonds
Now, let's take a more in-depth look at how to gain from the US treasuries.
Income from coupons
After purchasing a bond, you will usually receive periodic coupon income based on the face value of the bond and the coupon rate, usually paid semi-annually or annually.
Income from price differences:
Bond prices move with market fluctuations. As we mentioned before, lower priced bonds have higher returns to maturity. Therefore, if you buy a bond at a lower price, you will get a higher return at maturity.
Income from buying low and selling high:
Similar to stocks, bonds can be bought and sold in trades. This means you can make gains by buying low and selling high, just like stocks. However, bonds have relatively low price volatility compared to assets such as stocks, so the spreads may not be as large in the short term.
IV. Calculating bond returns
Now that we know how to earn income from US treasuries, let's explore how to calculate these returns in US treasuries investments, you often encounter two types of yields: the current yield and the yield to maturity.
Current Yield and Yield to Maturity:
The current yield is calculated based on the bond's current market price. It indicates the actual interest income you receive annually after purchasing the bond, considering only the current market price and the bond's coupon rate.
Calculation: Current Yield = (Annual Interest Payment) / (Current Market Price)
For example, if you purchase a $1,000 face value bond for $950 with a 2.5% coupon rate, the current yield is (0.025 * $1,000) / $950 = 5.26%.
Yield to maturity (YTM) is the total return you earn when you hold the bond until it matures. It measures the rate of return for buying the bond at different prices.
In general, the lower the bond price, the higher the YTM, and vice versa.
Calculating Yield to Maturity:
Next up is the big question: how do you calculate how much maturity gain you can get from buying a bond during the actual trading process? An example:
If you buy a $1,000 face value US treasuries with a 2.5% coupon rate for $950, and this bond matures in 5 years, how much money will you earn in total?
（1） Calculate annual interest income (Annual Interest Payment): The coupon rate is 2.5%, meaning you receive $25 in interest each year (2.5% * $1,000).
（2）Calculate the total interest income: Annual interest income × Holding Period = $25 × 5 years = $125.
（3）Calculate the principal income at maturity: Principal Income = $1,000 - $950 = $50.
（4）Calculate the total income at maturity: Total Interest Income + Principal Income = $125 + $50 = $175.
Isn't calculating yield to maturity simple? You can find a US treasuries and calculate the final income you'd earn together!
That's it for this lesson. In the next lesson, I'll continue to explain product selection and some simple US treasuries investment strategies. See you in the next lesson!