Bonds are fixed-income instruments that represent a loan made by the bondholder to the issuer, generally a corporate entity or the government. A bond has an expiry date, i.e., when the principal amount is due to be paid back. Bonds also include the terms of interest to be paid to the bondholder.
Investors and traders invest in bonds for two main reasons: earning a passive income in the form of interest and gaining bond yields. Consulting with a SEBI-registered investment advisor can help identify bonds that align with long-term financial goals.
What is a Bond Yield?
Bond yield refers to the return realized by an investor by investing in a bond. Bond yield can have multiple definitions, but the simplest explanation equates bond yield to its coupon rate. However, a long-term investment strategy often considers advanced calculations such as the time value of money at maturity (YTM), effective annual yield (EAY), and bond equivalent yield (BEY). An investment advisor can simplify these complex calculations for investors.
Breakup of Bond Yield
Investors lend money to the issuer when purchasing a bond. In return, the issuer agrees to pay interest throughout the bond’s validity and repay the principal amount upon maturity. The easiest method to compute bond yield is by dividing the coupon payment by the bond’s face value, known as the coupon rate.
For instance, if the face value of a bond is Rs. 1000 and it makes an interest or coupon payment of Rs. 100/- per annum, the coupon rate of the bond is 10%. However, bonds can be bought at a premium or discount, which can alter the yield for an investor. Working with a SEBI-registered investment advisor ensures that such variables are carefully considered within a long-term investment framework.
Bond Yield vs. Price
Bond yields fall as the price of a bond increases. For instance, an investor purchases a bond with a face value of Rs. 1000, maturing in 5 years with a 10% coupon rate. The bond pays Rs. 100 annually. When market interest rates increase above 10%, the bond’s price declines, making it less attractive.
An investment advisor can guide investors on navigating such market fluctuations and understanding how changes in bond prices affect their long-term investment portfolios. For example, if interest rates rise to 12%, the bond price might drop to Rs. 928 to offer a comparable yield. Conversely, if interest rates fall to 7.5%, the bond’s price might rise to Rs. 1101. Such dynamics highlight the importance of professional advice
Yield to Maturity (YTM)
Yield to maturity is equivalent to the rate of interest that makes the present value of a bond’s future cash flows equal to its current price. These cash flows include interest payments and the bond’s value at maturity.
For example, a bond with a face value of Rs. 1000, maturing in 5 years, and paying Rs. 100 annually will have a market value of approximately Rs. 928 if the YTM is 12%. Consulting with an investment advisor helps investors identify bonds with optimal YTM for their long-term investment strategies.
Bond Equivalent Yield (BEY)
Bond yields are often quoted as bond equivalent yield (BEY), which adjusts for semi-annual interest payments. For instance, if a bond’s half-yearly YTM is 5.98%, the BEY would be 11.96%. While BEY is a simplified annualized figure, an investment advisor can provide a detailed analysis to evaluate its fit in a long-term investment portfolio.
Effective Annual Yield (EAY)
Effective Annual Yield is a more accurate representation of a bond’s actual annual yield. For example, if a bond’s half-yearly YTM is 5.98%, the BEY is 11.96%, and the EAY is 12.32% due to compounding effects. These calculations are critical for long-term financial planning, where the expertise of a SEBI-registered investment advisor can provide clarity.
Complications in Calculating Bond Yield
Accurately calculating bond yield can be complex due to factors like fractional periods and accrued interest. For example, if a bond has 4 years and 8 months left to maturity, adjustments for partial years and accumulated interest are necessary.
Such intricate details emphasize the value of working with an investment advisor to navigate bond pricing and yield calculations as part of a long-term investment strategy.
Summary of Bond Yield
Bond yield represents the return earned by a bondholder from interest payments and the maturity value. While simple coupon yield calculations provide a starting point, comprehensive measures like YTM, BEY, and EAY offer a deeper understanding. A SEBI-registered investment advisor ensures these returns align with the investor’s long-term investment goals.
Bonds can be purchased through exchanges, over the counter, or via a registered broker. Collaborating with an investment advisor ensures informed decisions tailored to long-term wealth creation.
Savart is a SEBI-registered investment advisor, founded by Sankarsh Chanda. The purpose of this content is to educate, not to advise or recommend any particular security. Please remember that investments are subject to market risks. Please conduct thorough due diligence or seek professional guidance before making any investment. Do not believe in any speculations.