You can buy a bond either from the issuer when it is first issued at face value or in the secondary market at market price after it is issued. How much return you get from a bond will depend on when and at what price you bought it. In this article, we will learn how to use coupon rate and bond yield to calculate bond returns.
What is the coupon rate?
When an issuer issues a bond, they promise to pay a specified interest rate which they will pay at specified intervals (usually annually) during the term of the bond. The specified interest rate promised is known as the coupon rate. It is calculated on the face value of the bond. The coupon rate remains constant throughout the bond tenure, even if the bond price fluctuates in the secondary market.
The coupon rate is calculated using the following formula:
(Annual Coupon Amount / Bond Face Value) X 100
An investor can use the coupon rate to calculate the amount of interest they will earn from the bond during the holding period. Using the coupon rate, calculate the coupon amount for one year, and multiply it by the bond holding period (number of years).
For example, company ABC has come up with Rs. 50 crore bond issued with Rs. Face value Rs 100 and coupon rate 7% per annum for a period of 5 years. In this case, the company will give a coupon of Rs. Rs 7 per year on each bond unit.
If an investor buys a bond at the time of issue and holds it till maturity, they get a total of Rs. Will earn interest of Rs. 35 over a holding period of 5 years (annual coupon Rs. 7 x 5 years). After the bond is issued it is traded in the secondary market. The market value of a bond will fluctuate above or below the face value. However, this will have no effect on the annual coupon rate and coupon amount; They will remain stable.
What is bond yield?
In the previous section, we learned how to calculate the amount earned on a bond purchased at the time of issue using the coupon rate. However, many people buy bonds in the secondary market after they are issued.
In the secondary market, the bond may trade at a premium or a discount to its face value. In such a situation, how much return you will get from the bond will depend on the bond yield. Bond yield is the return that a bondholder will earn from holding the bond.
Even when a bond is purchased from the secondary market, the annual coupon rate and coupon amount will remain the same. However, a bondholder’s return from a bond will depend on the bond market price at which it was purchased.
Bond yield is calculated using the following formula:
(Annual Coupon Amount / Bond Market Value) X 100
Let us continue our previous example. One year after the bond is issued, assume that market interest rates have risen above 7% (coupon rate). The bond is trading at the current price of Rs. 99. Bond yield will be calculated as follows.
(7/99) x 100
= 7.07%
The bond yield is 7.07%
In this case, even though the coupon rate is 7%, the bond yield (7.07%) is higher because the bond was purchased at a lower price of Rs. Compared to its marked price of Rs 99. 100.
Let’s look at another scenario. One year after the bond is issued, suppose market interest rates have fallen below 7% (coupon rate). The bond is trading at the current price of Rs. 101. Bond yield will be calculated as follows.
(7/101) x 100
= 6.93%
The bond yield is 6.93%
In this case, even though the coupon rate is 7%, the bond yield (6.93%) is low because the bond was purchased at a higher price of Rs. Compared to its face value Rs 101. 100.
While the coupon rate remains constant throughout the bond tenure, the bond yield fluctuates with the bond market price.
Along with bond yield, an investor should calculate the yield to maturity (YTM). When a bond is purchased at a discount or premium to its face value and held to maturity, a capital gain or loss will occur as the issuer redeems the bond at face value at maturity. YTM takes into account coupons earned as well as capital gains/losses, to calculate the total annual return of the bond.
Why do bond yields matter to investors?
Bond yield tells you the income your bond will earn as a percentage of the price paid to purchase the bond. Bond yield helps an investor decide whether to proceed with the investment or not.
- Bond yield helps an investor assess whether the percentage return they will earn meets their expectations for that bond instrument, given risk and other factors.
- Bond yield helps an investor to compare a bond instrument with other similar bond investment opportunities available in the market and choose the most suitable option.
- Bond yield helps an investor compare a bond instrument with other fixed income investment opportunities available in the market, such as fixed deposits, and choose the most suitable option.
As with bond yields, an investor must calculate the YTM which gives the total annual return. To conclude, bond yield helps an investor to compare the bond instrument with other comparable financial products and make an informed investment decision.