What is bond yield and how to calculate it correctly?

My respects to all who came! In this article, I will look at the concept of bond yield. I’ll tell you in detail what this parameter consists of and what types of returns are available for debt instruments.

What influences them and how to properly conduct analytical work on such tools. What you should pay attention to first of all and how not to get confused in the variety of financial terms when it comes to bonds. I will definitely back up all this with real examples and understandable calculations.

What types of income do bonds have?

Profit on debt securities consists of several components:

1. Regular coupon income. This is the most understandable form of bond yield.
2. I will add income from the increase in the market value of debt instruments.
3. You can not discount the additional income due to tax incentives or special conditions.

All types of bond yield must be able to be combined with each other. In addition, yield can be calculated in different ways, for example, to maturity or at an effective rate, etc. It gets tricky, right? So now I will go through each point separately.

What does the coupon rate show?

The yield will be higher, because the interest can be refinanced and receive additional profit from investments. In rare cases, there are bonds without coupon income. In this case, interest is paid at the end of the maturity of the debt instrument.

Is interest on government bonds an income or an expense?

Fixed interest on bonds is always income for the investor. A simple example: the interest rate on government bonds is set at 8% per annum. The nominal price is 1000 rubles, and payments are made 2 times a year. This means that every six months the investor will receive a coupon income equal to 40 rubles.

Here I will make a reservation that such a calculation is relevant only for state and municipal bonds, as well as bonds issued after January 1, 2017, since they are exempt from personal income tax on coupons. Next, I will complicate the calculation a bit and demonstrate a combination of returns.

What are the formulas to calculate?

Bond yields can be calculated in different ways. You can only talk about coupon income or about the total yield, taking into account the growth of the body. But what if you need to calculate the income before the offer or at the time of the sale?

Each scenario will produce different numbers. But the main types of yield are current, to maturity and effective rate. I will consider each of them with examples.

Current

The current yield of bonds determines the ratio of the interest rate of regular payments to the purchase price of the bond. The formula is very simple and looks like this:

r =

• C is the annual coupon rate;
• P is the purchase price of the bond as a percentage of the face value.

This is the initial standard formula, the backbone, on which you can then add various accounting elements.

For redemption or sale

This type of return is focused on the amount of annual profit that the investor will be provided with for a specific holding period. The general formula looks like this:

r =

• N – face value;
• P is the market price of the bond;
• С – coupons for the holding period;
• D is the number of days of possession.

Those. if the investor holds this specific bond until maturity, then its yield will be 7.03% per annum. As you can see from this example, the yield turned out to be below the coupon rate, since the market price of the bonds is above par.

There are times when you need to calculate a bond's yield-to-sell. Then the face value and the market price in the formula are replaced by the selling and buying prices of IOUs.

Effective

Effective yield on bonds takes into account coupon reinvestment and loan amortization. It is generally recommended that all transactions and calculations be done in Excel. Using this program, find the exact figures for the internal rate of return of a bond.

However, I will show you how to do it with a piece of paper and a pen. Calculation formula:

r =  , where:

• N – face value;
• P is the market value of the bond body;
• n — number of periods to maturity;
• C is the coupon value.

More?

Of course, this is not an exhaustive list of methods for calculating bond yields. There are many formulas, but they are all modified versions of the basic calculations that I have given. In many ways, they depend on the properties of bonds, taxes, regularity of payments, etc.

And to obtain more accurate results, you can use computer software, where there are ready-made calculation formulas with labor-intensive calculations.

How to determine the annual return?

To do this, you can use standard mathematical methods. For example, an investor expects a 5% return in 182 days and a 15% return in 547 days. I apply the formula: in the first case, 365 days / 182 * 0.05 = 0.1, or 10%. In the second case, 365 days / 547 * 0.15 = 0.1 or 10%.

In both cases, reduction to a common multiplier showed that the annual return is the same and equal to 10%.

How to get the most out of a sale?

Benefit in excess of fixed interest income is provided by the increase in the body of bonds due to various factors. These moments primarily include a fall in general market interest rates.

There are also special stories when the issuer is obliged to pay additional money, for example, in case of early withdrawal of bonds. The investor needs to actively use tax and other deductions, getting as much benefit as possible.

Early repayment restrictions

In case of revocation of IOUs, the issuer is obliged to pay the face value and the premium. As a rule, it is equal to one annual coupon.

The investor may also have the right to demand early redemption of the bond. Then the face value and accumulated coupon income from the last payment period will be returned to the creditor. However, the bearer will have to incur some corporate costs in submitting the application for withdrawal.

Revocation requirements may be subject to certain restrictions. For example, the maximum percentage to be presented of the total number of papers in circulation. All conditions and restrictions must be described in the bond issue prospectus.

How to make money on Eurobonds?

Eurobonds are bonds that are traded in foreign currencies.

As in ordinary bonds, the investor has the opportunity to receive coupon income and earn from the increase in value.

In addition, when working with Eurobonds, it is necessary to take into account fluctuations in exchange rates: the devaluation of the national currency will contribute to greater profits in rubles, and the strengthening of the domestic currency will reduce the final yield.

How to choose bonds?

There are several factors to consider when choosing bonds. You need to find your balance between risk and return. Here everything will depend on the aggressiveness of the investment strategy.

The investor sets the expected investment period and, based on this, varies his investments, choosing reliable government bonds with a conservative strategy or high-yield, but more risky corporate or municipal bonds.

What to pay attention to first of all?

If we talk about investments in corporate bonds, then it is necessary to take into account the credit rating of Russian issuers. The regularity of coupon payments and the currency of circulation also play a significant role in choosing bonds.

How much can you earn?

The most reliable and liquid bonds, such as short OFZs, are capable of yielding 6-7% per annum. Municipal bonds have an average coupon yield of 8-10% per annum. And corporate bonds will give the highest rate of return, however, the risks in them are much higher.

Of course, here we are talking about average values, in some cases, returns can be highly shifted. In addition, it should be remembered that you can earn on the growth in the value of the body of bonds.

Is it profitable to buy?

Allocation of funds in a portfolio of debt securities can be very profitable. Compared to the deposit alternative, bonds are a big winner. They can bring high returns with appropriate risks.

In addition to the main coupon income, the terms of circulation also belong to the advantages of bonds. For example, an investor can almost always sell bonds on the secondary market, keeping the accumulated income. And more regular payments provide a greater effect on the reinvestment of funds.

Can I buy on IIS?

Bonds can and should be bought on individual investment accounts. The purchase of bonds in this way allows the investor to receive a special tax deduction. 

Where can I see the list of securities available for purchase?

You can see current issues and market prices of bonds in brokerage terminals. Investors also use special aggregator sites on financial topics. 

How much is 1 piece?

Bonds denominated in foreign currencies have an initial value of $1,000.

Sometimes bonds are sold in exchange lots, in which case the entry threshold can be greatly increased. But now there is an opportunity to buy structured products such as mutual funds or ETFs. In these instruments, the entry threshold is very low, accessible to almost any private investor.

Where and how can you buy?

There are different ways. You can buy bonds from a bank or from a company directly. But it is best to use the services of a licensed Russian broker.

Independently on the stock exchange

To do this, you need to open an investment account in one of the brokerage houses. Next, the investor downloads an interactive terminal and gets access to trading instruments on the stock exchange.

As part of the PIF

Mutual funds include a whole range of assets. This provides a wide level of diversification combined with a low financial entry threshold. However, such instruments have a number of disadvantages: PIFs are not traded online, and prices are set only at the end of the trading session. In addition, the negative side of the PIF is low liquidity.

ETFs

Exchange-traded funds are the same structural products as mutual funds, which include a set of different assets. There are a small number of ETFs on the Russian market. They differ in that they have online quoting and high liquidity.

How to choose a method?

If an investor is interested in a specific bond, it is better to simply buy it separately through a broker. When standard diversification is needed or an instrument with a high entry threshold is needed, structured products should be used. Other things being equal, between ETFs and mutual funds, it is worth giving preference to the first.

Top Brokers

The biggest brokers, in my opinion, outperform the smaller ones in the industry. They have competitive commissions and a higher level of reliability. In addition, big players provide better services for working on the stock exchange.

Investor reviews

Market participants almost always favor the debt market: here you can find options with higher yields and liquidity than comparable investment instruments.

Taxation for individuals

Government, municipal, and corporate bonds (issued after January 1, 2017) are exempt from coupon income tax. When sold on the secondary market, a 13% tax will be imposed on the increase in the value of the body.

Which is better: government or corporate?

But returns are often more attractive in the corporate sector. Therefore, the investor must choose regarding the planning horizon and his risk appetite.

Conclusion

Summing up, I want to say that bonds are an extremely attractive instrument for market participants. And the returns on them, as has been shown, range from minimal amounts to astronomical percentages.

All this gives a huge scope for action for private investors. And if you correctly approach the process of assessing profitability against risk, there are enormous opportunities for capital growth.

I hope it was interesting, and most importantly, useful. Be sure to subscribe to articles and share them on social networks.