Real Returns. Making sense of coupons, yields and YTMs

With stock market returns waning, many retail investors are today seeking comfort in the fixed returns offered by bonds. The fund crunch for NBFCs has prompted many of them to tap the market with public issues of bonds. Apart from this, many investment platforms offer recommendations on bonds traded in the secondary markets. But bond recommendations are often accompanied by an alphabet soup of jargon. Here’s making sense of the terms.

Coupon rate

The coupon rate is the actual interest expressed in percentage terms that the borrower proposes to pay you at annual intervals. If you are investing in bonds with a face value of ₹1,000 and a coupon rate of 8.5 per cent, you will receive ₹85 by way of interest from the issuer every year. The higher the coupon rate, the higher the return you will earn from the bond. However, do remember that an issuer’s willingness to pay a high coupon rate on a bond is also an indicator of how risky he is perceived to be by the market.

Effective yield

When the issuer of a bond pays out the interest at a monthly, quarterly or half-yearly frequency, he usually advertises an ‘effective yield’ that is higher than its coupon rate. Calculations of effective yield assume that when you receive the interest at monthly, quarterly or half-yearly intervals, you will re-invest this money elsewhere at the same rate to earn returns from it.

For bonds with an annual payout, the effective yield is equal to the coupon rate. But for bonds with monthly, quarterly or half-yearly payouts, the effective yield is higher due to the impact of compounding on the interest received.

When evaluating bonds that pay out regular interest, do remember that your cash inflows from the issuer will be equal to the coupon rate and not the effective yield. If you plan to spend your interest receipts or park them in a savings bank account, your returns will be closer to its coupon rate than the effective yield advertised by the issuer.

Effective-yield calculations are also used to showcase the compounded annual returns on cumulative bonds. For bonds with a face value of ₹1,000, where the maturity value is ₹1,504 at the end of the five years, the effective yield works out to 8.5 per cent per annum. In the case of cumulative bonds, the effective yield actually represents the returns you stand to make on the bond.

Current/market yield

Though a bond is issued at a fixed face value during a public issue, its market price can move above or below its face value post-listing. Whether a bond trades at a premium or discount depends on two factors — movements in the market interest rates after the bond was issued, and the market’s perception of whether the issuer will default.

If general interest rates in the market move up after you have bought a bond, the market price of the bond will fall below face value. This is because now new bonds in the market offer better rates to investors, causing them to dump your bond. If general interest rates in the market fall after you bought your bond, its market price will shoot up as it will be much in demand.

If the issuer is sound and you plan to hold the bond to maturity, changes in its market price do not matter to you as the issuer will repay your maturity proceeds at face value. But if you are looking to sell the bond before its term, or buy one from the secondary market, tracking its market yield becomes important. The current yield of a bond is calculated by dividing its coupon payment by its latest market price. In the above example, if the market price of the 8.5 per cent ₹1,000- face value bond fell to ₹900 after a year, its market yield would be 9.4 per cent (₹85/₹900).

When evaluating bonds for secondary market investments, it is important not to get carried away by market yields and to compare them against issuers with similar credit ratings from a similar industry.

A very alluring yield is often a sign of the bond suffering a rating downgrade after the issue, or the market believing that the issuer carries a high probability of default. Poor market liquidity in a bond can also lead to outlandish market yields. Investing in all such ‘high yield’ bonds can cost you your capital.

Yield-to-maturity

While the current yield captures the immediate returns on a bond, the yield-to-maturity (YTM) captures the effective return that you are likely to earn on it if you buy it at its current traded price and hold on until maturity. YTM calculations capture the effective rate of return at which a bond’s future cash flows by way of interest and principal repayments will equal its current market price.

But if you are looking to sell the bond before its term, or buy one from the secondary market, tracking its market yield becomes important. If you assume that a ₹1,000- face value bond with a coupon of 8.5 per cent has four years left to maturity and trades at ₹900 today, its YTM will be 11.78 per cent.

Investing in bonds based solely on high YTMs carries the same pitfalls as investing in those with a high current yield. Bonds that trade at very high YTMs in the market (compared with peers/similar rated entities) are often those that have seen big market sell-offs due to credit downgrades or rising default risks. In June, different bond series’ of DHFL offered YTMs of anywhere between 25 per cent and 200 per cent based on their prevailing market prices.

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