Considered as a safe investment option, Bonds offer an investor an option of generating income in an environment where there is significant mitigation of risk as compared to equity related investments. Generally investment in bonds can be of two types i.e. investment in an individual bond or investment in a bond fund. Investing in an individual bond is considered a relatively safer mode of investment as the principal amount invested remains safe if the bond s held until maturity. The principal in the case of an investment in a bond find is subjected to market fluctuations and there are chances that the amount might get eroded over time.
The bond issuer or the borrower enters into a legal agreement with the investor or lender, to repay the principal amount along with certain returns. Funds of these nature are usually generated by the government and its various departments to invest in some public or community development works like building of roads, bridges, technological advancement etc.
The annual rate of interest that is paid to the investor on the amount invested by him, mostly applicable in the case of individual bonds, is known as the Coupon rate. Always depicted as a percentage of the face value of a bond, the coupon rate is tied to the value at par.
For example, if a person invests $10000 in a five year bond paying a coupon rate of 5% per year, semi-annually. If the person holds the bond up to maturity, he would receive ten coupon payments of $250 each and a total amount of $2500
These bonds can also accrue interest, which implies that if a bond is purchased or sold in the time period between coupon payment dates, then interest is applicable for the difference in the number of days. Thus, if one plans to sell the bond before the coupon payment date, then he would get the entire price of the bond along with the interest accrued up to the sale date.
There exist bonds that do not give out any coupon or interest payments. Such bonds are called zero coupon bonds or zeros.
Yield is a measure that helps an insurer compare between multiple bonds that are available and make a conscious decision to buy the one that provides the best returns. This is simply a calculation of the return on the capital invested by the investor. There are multiple ways in which this yield is calculated, some of which are illustrated below:
- Coupon Yield: This is same as the coupon rate and is the amount that is earned as interest which is usually a percentage of the face value of a bond.
- Current Yield: In this form of calculation, the market price of the bond has a bearing upon the interest calculation. To arrive at this figure the coupon yield of the bond has to be divided by its market price. The price at which the bond is traded on a particular day would have an impact on this figure. The higher the market price the power the yield. In this sense the market price of the bond and its yield are inversely related.
- Yield to Maturity (YTM): This amount is calculated by taking into consideration the following scenario: a person investing in the bond holds the bond up to its maturity and then re-invests all the earnings from the interest earned at the YTM rate.
- Yield to Call (YTC): Quiet similar to YTM, this takes into consideration the bond’s call price instead of the maturity tenure.
- Yield to Worst: This is a comparison between a bond’s YTM and YTC. This takes into consideration the most conservative returns that is possible on a bond.