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Bond Returns and Yields

While stocks offer "ownership," Bonds offer "lending." When you buy a bond, you are lending money to a company or government. Measuring the return on this loan is more complex than just looking at the interest rate.

1. Key Terminology of Bonds

Before calculating returns, we must understand the "tags" attached to every bond:

  • Face Value (Par Value): The amount the bondholder will receive at maturity (usually ₹1,000 or ₹100).
  • Coupon Rate: The fixed annual interest rate paid by the issuer.
  • Maturity Date: The date when the loan ends and the principal is returned.
  • Redemption Value: The amount paid at maturity. Usually same as Face Value.

2. Measuring Bond Yields

There are different ways to express the return on a bond, depending on the investor's perspective.

A. Coupon Rate

This is the "Nominal" interest rate printed on the bond certificate.

  • Formula: (Annual Interest / Face Value) × 100

B. Current Yield

This measures the return based on the Current Market Price, not the Face Value.

  • Formula: (Annual Interest / Current Market Price) × 100

C. Yield to Maturity (YTM)

The most important yield measure. It is the total return expected if the bond is held until it expires. It accounts for all interest payments + the gain/loss made at redemption.

  • Approximate Formula: YTM = [C + (FV - MP) / n] / [(FV + MP) / 2]

Where: C = Annual Coupon, FV = Face Value, MP = Market Price, n = Years to maturity.

D. Yield to Call (YTC)

Used for "Callable Bonds" where the issuer has the right to pay back the loan before maturity. The calculation is similar to YTM, but uses the Call Price and the Time to Call.

3. Spot Interest Rate

The Spot Rate is the yield on a "Zero-Coupon Bond" (a bond that pays no interest but is sold at a deep discount). It represents the market's expectation for interest rates for a specific future date.

Practical Examples (Exam Style)

Problem 1: A bond has a face value of ₹1,000 and a coupon rate of 10%. If the current market price of the bond is ₹900, calculate its Current Yield.

Solution:

  • Annual Interest (Coupon) = 10% of 1,000 = ₹100
  • Market Price = ₹900
  • Current Yield = (100 / 900) × 100 = 11.11%

Problem 2: A 5-year bond with a face value of ₹1,000 pays an annual coupon of 8%. The current market price is ₹950. Estimate the Yield to Maturity (YTM).

Solution:

  • C = ₹80 (8% of 1,000)
  • FV = ₹1,000
  • MP = ₹950
  • n = 5
  • YTM = [80 + (1000 - 950) / 5] / [(1000 + 950) / 2]
  • YTM = [80 + 10] / 975 = 90 / 975 = 9.23%

Exam Pattern Questions and Answers

Question 1: "Differentiate between Coupon Rate and Yield to Maturity." (6 Marks)

Answer:

  1. Definition: Coupon Rate is the fixed interest rate the issuer agrees to pay on the face value. YTM is the total estimated return the investor will earn if they hold the bond until maturity.
  2. Basis: Coupon rate is based on the Face Value. YTM is based on the Current Market Price and the time remaining.
  3. Nature: Coupon rate remains constant throughout the life of the bond. YTM changes every day as the market price of the bond fluctuates.
  4. Components: Coupon rate only includes the interest income. YTM includes both interest income and the capital gain or loss (the difference between the price paid and the principal received at maturity).

Question 2: "What is 'Yield to Call' and why is it important for an investor?" (4 Marks)

Answer: Yield to Call (YTC) is the return an investor will receive if a callable bond is redeemed by the issuer before its maturity date. Significance:

  1. Risk Assessment: Many corporate bonds are "Callable," meaning the company can pay you back early if interest rates in the market fall.
  2. Realistic Return: If a bond is likely to be called, the YTM becomes irrelevant. The investor should look at YTC as it represents the more 'realistic' worst-case or expected return.
  3. Decision Making: It helps investors decide if the "Premium" paid for a callable bond is worth the risk of an early exit.

Summary

  • Coupon is the fixed contract; Yield is the actual performance.
  • When market price < face value, Current Yield > Coupon Rate.
  • YTM is the standard measure for comparing different bonds.
  • Zero-coupon bonds use Spot Rates for valuation.

Quiz Time! 🎯

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