Returns & Prices
What is the return on a bond?
Coupon is the rate of interest paid by the issuer to the holder until the bond matures. It is usually expressed as an annual percentage of the face value; it may be paid annually, semi-annually or more frequently.
For example, if you purchase a £1,000 bond par value with a coupon of 4% per annum paid semi-annually, you will receive an interest payment of 4% per annum (2% every six months) throughout the life of the bond.
The interest rate on a bond may be fixed, so predetermined and fixed for the life of a bond, or on a floating rate basis and linked to short-term interest rates ('reference rates' such as the London Interbank Offered Rate (LIBOR)).
What determines the price of a bond?
Bond prices depend on a variety of factors, such as:
- Interest rates
- Supply and demand
- Credit quality
Newly issued bonds generally sell at or near their face value. Prices for bonds traded in the secondary market will fluctuate as interest rates move up or down. Bond prices have an inverse relationship with interest rates. If interest rates move up, bond prices move down and vice versa.
You can track bond prices in the financial press or on the Internet. Euro-denominated bond prices are quoted in decimals. The price quoted will depend on whether accrued interest is being taken into account (clean price or dirty price). Bond prices are usually quoted "clean", i.e., without accrued interest. The clean price is, in effect, the price of the bond on the first day of the coupon period. The "dirty" price of a bond is, therefore, the price of a bond including accrued interest.
When will your loan be repaid?
A bond's maturity date refers to the date on which the issuer will repay the principal amount to the investor.
Maturity ranges are often divided into the following categories:
- maturities up to one year (short-term notes)
- medium-term notes/bonds with maturities of one to five years
- long-term bonds with maturities in excess of five years
- credit quality
The credit quality of bonds varies from the highest quality gilts, which are backed by the full faith and guarantee of the UK government to speculative bonds that are rated below investment grade.
Generally speaking, bonds with good quality credit ratings trade at a lower yield than bonds with poorer credit ratings. This is because investors expect a higher return for the greater risk of investing in bonds with an increased chance of default on behalf of the issuer.
How can you calculate your return?
One of the key advantages bonds have over stocks is that they offer relatively predictable returns. But precisely measuring these potential returns in advance can be tricky.
Two measures of bond returns (yields) are current yield and yield to maturity (YTM).
When you buy a bond, the return consists of the following three elements:
- the promised interest payment
- interest on interest (the compounding effect of reinvesting the periodic interest payments)
- capital gain or loss on redemption or disposal of the bond
YTM takes account of all three sources of return and is therefore a more accurate measure than current yield, which takes account of only the interest payments.