Bonds have a low but stable return. This is mainly because you run little risk with bonds. Because of the perfect relationship between stable return and low risk, it is often an important part of most portfolios. However, there are a few pitfalls in the yield on bonds. For example, it is important to calculate the effective return instead of blindly using the coupon rate as your effective return. Before we proceed, it is important that you know how a bond is constructed.
Return on Bonds
By now you know that a bond consists of the following elements: the nominal value, an interest rate and a specific term. With this data it is possible to calculate the yield of the bond. Suppose you buy a bond with an interest of 3% and a term of 5 years. First, we want to know how much dollar we earn on this. Secondly, we want to know what the yield is on this bond.
You start with the purchase of the bond, which leads to -1,000 dollar. You will then receive 3% annually on this 1,000 dollar. This amounts to 30 dollar. So after 5 years you have received a total of 150 dollar in interest. When the term of 5 years has been reached, you get back the nominal value of the bond, which is 1,000 dollar. In total, you therefore received 1,150 dollar and spent 1,000 dollar. This is a profit of 150 dollar. To calculate the return, we use the formula: (new – old) / old / term x 100%. If we fill this in it becomes: (1150 – 1000) / 1000/5 x 100% = 3%.
This 3% makes sense because this is exactly the interest on the bond. This is a simple version of calculating your return on the bond. This calculation only works if you have bought your bond at exactly the same price as the nominal value. But almost always you buy bonds at a certain price and rarely for the nominal value.
Calculate the Effective Return
The effective return takes into account a number of additional issues compared to the previous calculation. The price is included in this calculation. In addition, “hidden” losses must be taken into account. There are hidden losses when, for example, you can earn more money with an alternative investment (with the same or less risk).
As an example, we take a 2-year bond with 4% coupon interest. This time you buy the bond on the free market at a price of 102%. This will be option A. Option B is a 2-year savings account deposit. The return on this savings account is 3%.
Which Option do you choose?
Option A remains approximately the same as above. However, you now start at -1,020 dollar, due to the fact that the price is 102%, the profit via interest in now 4% over 1,000 dollars for 2 years = 80 dollar. Finally, you will receive the 1,000 dollar back on redemption of the bond. This amounts to a total profit of -1020 + 80 + 1000 = 60 dollar. To calculate the effective return on the bond, we must divide the profit by the purchase price. The duration must also be taken into account. We do this in 2 steps.
- Profit per year = 60/2 = 30 dollar
- Effective Return Bond = 30/1050 = 2.86%
We can immediately see that the bond’s effective yield is 0.14% lower than the yield on the savings account deposit. However, the effective return on the savings account is not 3% but 3.19% thanks to the strength of the interest-on-interest effect. Of course, you could reinvest the interest on the bonds, giving you a slightly higher return (just like the extra 0.19% on the savings account).
Your Realistic Effective Return
This example has been used illustratively to show how to calculate the effective return on bonds. The purpose of this example is to guard against the pitfalls that other novice investors do fall into. Take a look at the numbers behind the numbers. A return of 5% sounds very attractive, but if you have to pay a price of 105% to buy the bond and it only runs for 1 year, then you earn exactly 0 dollar (-1,050 + 50 + 1000).
So first calculate the effective return before buying a bond. If this effective return fits within your investment strategy, buy the bond. However, you now know how to calculate the return and you can now make this decision better. The one point you still have to guard against is the risk of bond.