You can buy a bond either from the issuer when it is issued for the first time at face value or from the secondary market after issuance at the market price. The return you will earn from the bond will depend on when you bought it and at what price. In this article, we will learn how to use the coupon rate and bond yield to calculate bond returns.
What is the coupon rate?
When an issuer comes out with a bond issue, they promise to pay a specified interest rate that they will pay at specified intervals (usually annually) throughout the bond’s tenure. The promised specified interest rate is known as the coupon rate. It is calculated on the bond face value. 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 interest amount that they will earn from the bond over the holding period. Using the coupon rate, calculate the coupon amount for a year, and multiply it by the bond holding period (number of years).
For example, Company ABC has come out with a Rs. 50 crores bond issue with a Rs. 100 face value and a 7% coupon rate per annum for a tenure of 5 years. In this case, the company will pay a coupon of Rs. 7 every year on each bond unit.
If an investor buys a bond at the time of issuance and holds it till maturity, they will earn a total interest of Rs. 35 (annual coupon Rs. 7 X 5 years) over the 5-year holding period. After the bond issuance, it trades in the secondary market. The market price will fluctuate above or below the bond face value. However, this will not affect the annual coupon rate and the coupon amount; they will remain constant.
What is bond yield?
In the earlier section, we learned how to calculate the amount earned on a bond purchased at the time of issuance using the coupon rate. However, many people buy bonds from the secondary market after their issuance.
In the secondary market, the bond may trade at a premium or a discount to its face value. In such a scenario, the return that you will earn from the bond will depend on the bond yield. A bond yield is the return that a bondholder will earn from holding a bond.
Even when a bond is purchased from the secondary market, the annual coupon rate and coupon amount will remain the same. However, the bondholder’s return from the bond will depend on the bond market price at which it was bought.
The bond yield is calculated using the following formula:
(Annual coupon amount / Bond market price) X 100
Let us continue with our earlier example. After one year of bond issuance, suppose the market interest rates have increased above 7% (coupon rate). The bond is trading at a current price of Rs. 99. The 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 bought at a lower price of Rs. 99 compared to its face value of Rs. 100.
Let us look at another scenario. After one year of bond issuance, suppose the market interest rates have fallen below 7% (coupon rate). The bond is trading at a current price of Rs. 101. The 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 lower because the bond was bought at a higher price of Rs. 101 compared to its face value of Rs. 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 must calculate the yield to maturity (YTM). When a bond is bought either at a discount or premium to its face value and held till maturity, there will be a capital gain or loss, as the issuer redeems the bond at face value on maturity. The YTM takes the capital gain/loss into account, along with the coupons earned, to calculate the bond’s total annualised return.
Why does bond yield matter for investors?
The bond yield tells you the income that your bond will earn as a percentage of the price paid to purchase the bond. The bond yield helps an investor make an informed decision about whether to proceed with the investment or not.
- The bond yield helps an investor assess whether the percentage return they will earn meets their expectations for that bond instrument, given the risk involved and other factors.
- The bond yield helps an investor compare the bond instrument with other similar bond investment opportunities available in the market and choose the most appropriate one.
- The bond yield helps an investor compare the bond instrument with other fixed-income investment opportunities available in the market, such as fixed deposits, and choose the most appropriate one.
Along with bond yield, an investor must calculate the YTM that gives the total annualised return. To conclude, the bond yield helps an investor compare the bond instrument with other comparable financial products and make an informed investment decision.
