A bond is a fixed income instrument which is a loan made by an investor to a borrower. It is a long term agreement between the borrower and the lender. If you invest in a bond you get interest payments across the tenure. (This is for how long you hold the bond).
Let us understand how a bond works with an example. Take the HDFC 9.5% 2016 Bond issued on 19th July 2006 with annual payment of interest.
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What is Bond Yield?
There are two factors which impact the price of the bond:
The time to maturity of a bond changes each day as the bond moves towards maturity date. To get the value of the bond you measure the distance of each cash flow (This is the present value of the bonds future interest payments) to the maturity date. This means the value of the bond changes with change in tenure, even if all other factors are constant.
The discounting rate of a bond is the bond yield and is determined by market forces. The value of the bond cannot be any arbitrary rate. The bond rate depends on market rate for bond tenure and the credit quality. The discounting rate cannot be static. It changes depending on tenor left to maturity (residual tenor) and the credit quality of the bond.
Bond yield is basically the annual return on investment. It depends on the purchase price of the bond and the coupon payment (interest promised).
The price of the bond and the interest are inversely proportional. This means when bond prices fall, interest rises and vice versa.
Let’s understand bond yield with an example:
Bond Yield Formula:
Yield of a bond = Coupon amount / Bond Price * 100
A bond has a face value of Rs 1,000 and the investor can earn 6%. The coupon rate is 6% and the investor who buys the bond and holds it to maturity earns Rs 60 a year across bond tenure.
Let’s say the price of the bond drops to Rs 980. The current yield of the bond is Rs 60 divided by Rs 980 which is 6.12%.
What happens if the bond price rises to Rs 1,030. The current yield of the bond is 60/1030 = 5.82%.
When the price of the bond rises, the yield decreases. As the price of the bond falls, the yield increases.
SEE ALSO: What is Bond Yield?
What is Current Yield?
Current yield is calculated by dividing bonds coupon rate by purchase price. Let’s say the bonds coupon rate is 6% on face value of Rs 1,000. The current yield is Rs 60 / Rs 1,000 = 6%.
What would happen if you purchased the bond at a discount to face value? You purchased the bond at a discount to face value of Rs 900.
The current yield is Rs 60 / Rs 900 = 6.67%.
Yield to Maturity:
A bond yield to maturity (YTM) reflects interest payments from the time of purchase until maturity. (This includes interest on interest).
Let’s understand YTM with an example:
Par value of bond = Rs 1,000.
Coupon rate = 10%
Years to maturity = 10 years.
Market Price = Rs 920.
Annual Interest = Par value of bond * Coupon rate = Rs 1,000 *10% = Rs 100.
YTM = 100 + (1000 – 920) / 10 / 1000 + 920 / 2
YTM = 11.25%.
Impact of bond yields:
What happens if bond yield rises? Rising yields make equity investors sweat. If bond yields rise it’s bad for stock markets.
SEE ALSO: What is Current Yield?
There Aae Two Ways to Make Money from Bonds:
Bonds pay interest. This is a smart way of making money from bonds. You can also make profits by selling bonds at a higher price than you purchased them for.
So how to make money from bonds? Buy bonds and hold till maturity. You earn interest regularly. You can also trade bonds on the secondary market. There are variety of bonds with varying interest rates and maturity.
The interest rate in the market keeps changing and so does the demand for bonds. Bonds offering higher coupon rate have higher demand. Investor rush to pick up these bonds and make money.
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