Simplifying personal finance: What is bond yield? In the second part of this series, Riju Mehta explains bond yield and how it is calculated
To understand bond yield, you will first need to know about bonds and some terms associated with these..live_stock{left:17px;padding:1px 3px 1px 5px;font-size:12px;font-weight:600;line-height:18px;top:9px} #sr_widget .sr_desc{margin:0 auto 0;} #sr_widget .sr_desc{color: #024d99;margin-top:10px;} #sr_widget .crypto .live_stock .lb-icon{8px 6px 5px 3px !important} #sr_widget.crypto a.text{border-bottom:1px solid #ccc;padding-bottom:5px;display:block;width:100%} #sr_widget .sr_desc .text p, #stock_pro .sr_desc .text p{font-size:12px;font-weight:400;} Modi 3.0 Live
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Bond
It’s a fixed-income debt instrument issued by a government or corporation. Simply put, it’s a loan you give to an entity, which promises to return the invested amount after a fixed period, and gives you a pre-decided rate of return on the invested amount. So, the bond certificate is, in a sense, an IOU that the issuer gives to you.
Issue price
This is the price at which the entity or issuer sells the bond in the primary market.
Face or Par value
This is the amount that the issuer promises to return on maturity of the bond. The issue price may or may not be the same as par/face value.
Market price
This is the price at which bonds are bought or sold in the secondary market. If a bond is sold at less than its face value, it’s at a ‘discount’, and if it’s sold above its face value it’s at a ‘premium’.
Coupon rate
The fixed annual interest rate (in percentage) on the face value of the bond for the entire holding period is called coupon rate.
Maturity date
The date on which the issuer returns the entire invested amount to you is called maturity date.
To understand it with an example, suppose an issuer sells a bond in the primary market on 1 January 2024 at Rs.1,000, at par, and offers an interest rate of 10%. He promises to return the capital after 10 years, on 1 January 2034.
If you decide to buy it from the secondary market for `1,100, it will be at a ‘premium’, and if you buy it for Rs. 900, it will be at a ‘discount’.
What is bond yield?
It’s the annual return you get as a percentage of your total bond investment. It is expressed as the entire coupon payment reveived by you in a year (return), divided by the face value of the bond. Considering the earlier example...
What is current yield?
This depends on the current market price of the bond. So, if the market price of the bond is Rs.1,100, then current yield will be the entire coupon payment you get in a year (return) divided by the market price, as follows:
Bond yield vs price vs interest rates
Bond prices are inversely proportional to the interest rates and yield. Let us understand with an example. If bond price is Rs.1,000 and coupon rate is 5%, which is also the prevailing interest rate, then the annual coupon payment would be Rs.50 and bond yield would be 5%.
If the interest rate rises to 6%, the existing bonds will become less attractive because the new bonds will give Rs.60 coupon for Rs.1,000 purchase price. Since the coupon of existing bonds is fixed at Rs.50, the price of existing bonds will have to reduce to match the prevailing rate of 6%. Hence, in this case, it will fall to Rs.833 (50/ 0.06). The yield, too, will rise to 6% (50/833 x 100).
If, on the other hand, interest rates fall to 4%, the price of existing bonds will rise because they will become more attractive as they are paying a higher coupon rate of 5%. So, you will need to pay more to match the prevailing rate. The price will rise to Rs.1,250 (50/ 0.04), and yield too will fall to 4% (50/1,250 x 100).
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This story originally appeared on: India Times - Author:Faqs of Insurances
