The Hindu Business Line : Bond returns

Current yield: Bonds are listed in the market and can, therefore, be bought and sold at any time. Current yield indicates the rate of return that you will get immediately on buying the bond.

This is the ratio of interest on the bond to market price of the bond. For instance, if a bond with a coupon value of Rs 1,000 and a coupon rate of 7 per cent can be bought in the market at Rs 950, the current yield is Rs 70/950 x 100 = 7.36 per cent.

Bond Yield: The reward for investing in a bond is the interest payment and the premium on redemption. If the bond is issued at a discount, then the extent of the discount also constitutes a reward for the investor.

Bond yield refers to the rate of return the initial investor (he who invests in the bond at the time of the issue of the bond) will earn if he holds the bond till its maturity. This is computed by laying down the cash flow structure across the life of the bond and computing its Internal Rate of Return (IRR).

Yield-to-maturity (YTM): This indicates the rate of return an investor who buys the bond in the market today earns if he holds the bond till maturity. This is computed by laying down the cash flow structure from the date of purchase to the maturity of the bond and then computing its IRR.

You guessed it right. Bond yield is the same as YTM except that the phrase is used with reference to the investment made at the time of issue.

In the market place, bonds do not necessarily sell at par. They can sell above or below par value.

Some use the phrases par bond, premium bond and discount bond to denote this situation. If it sells at par value, it is called par bond; if it sells above par, it is referred to as premium bond and if it is available below par, it is known as discount bond.

But why is it that some bonds trade at par and others trade at a premium or at a discount?

To understand this, that we need to know about two rates — the expected rate and the actual rate and of how the market plays the role of the great leveller.

To keep the example, let’s say Bond X is issued at a par with a coupon of 9 per cent. One year later, say, the bond still trades at Rs 100. This means that the actual return is 9 per cent.

Now, assume that investors want to earn 11 per cent (expected return) because elsewhere on a bond of similar risk, say, Bond Y, they get that rate. Company X is not mandated to increase the coupon rate and would in fact not do so.

Guess what would happen now? Investors would sell these bonds and buy those that offer 11 per cent. But who will buy these bonds? Will there be a market? Yes, people will buy provided the price is attractive.

Since others also want 11 per cent, the price will be attractive only when the bond drops in value to Rs 82. Note Rs 9 on an investment of Rs 82 will translate into a return of 11 per cent. As selling pressure builds, the price will in fact drop to Rs 82. In short, the bond will start quoting at a discount.

The message: If a bond offers a rate of return which is less than the market rate, it would start quoting at a discount. By the same analogy, if the bond offers a coupon which is greater than the market rate, it would start quoting at a premium. And, finally, if it offers a coupon exactly equal to the market rate it will continue to trade at par.

Now, if you are excited by a premium bond or a discount bond, hold on. It merely means that the coupon rates are higher or lower than expected return.

With the price readjusting itself, the YTM turns out to be the same. Little wonder, we love the market economy.

(The author is a Chennai-based chartered accountant.)

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