In the world of finance, bonds are essential instruments that enable governments and companies to raise funds from investors as well as allows the Central Bank to regulate the liquidity or money supply in the market. Are you wondering how? Understanding bonds and their associated yields is crucial. Let’s understand the basics of bonds and bond yields and how to understand the implication.
What are Bonds?
Imagine you have some extra money and want to lend it to a government or a corporation. Instead of handing over the money directly, you can purchase a bond. A bond is essentially a loan made by an investor to an entity, with the promise of repayment at a future date, along with periodic interest payments.
For instance, let’s say the government of India issues a bond with a face value of Rs 10,000 and an annual interest rate of 5%. When you buy this bond, you’re lending Rs 10,000 to the government, and in return, they promise to pay you 5% of the face value, which is Rs 500, every year until the bond matures.
Bond Yields: How are they different from Bonds
Bond yields represent the return an investor earns from holding a bond. They are typically expressed as a percentage of the bond’s face value. Let’s explore the different types of bond yields with examples:
Coupon Yield: This is the annual interest rate that the bond pays. Continuing with our example, if the government bond has a face value of Rs 10,000 and pays an annual coupon yield of 5%, it means you’ll receive Rs 500 per year as interest.
Current Yield: Current yield measures the annual return on a bond based on its current market price. Suppose you buy the same government bond for Rs 9,500 instead of its face value of Rs 10,000. In this case, the current yield would be calculated by dividing the annual interest payment (Rs 500) by the current market price (Rs 9,500), resulting in a current yield of approximately 5.26%.
Yield to Maturity (YTM): YTM represents the total return anticipated on a bond if it’s held until maturity. It considers both the interest payments and any potential capital gains or losses. Let’s assume you hold the government bond until maturity, and upon maturity, you receive the face value of Rs 10,000. If you purchased the bond for Rs 9,500, your YTM would include both the interest payments and the capital gain of Rs 500.
Yield to Call: Some bonds can be called back by the issuer before their maturity date. Yield to call calculates the yield if the bond is called back by the issuer at the earliest possible date. For example, if the government bond in our example is callable after five years, the yield to call would consider the interest payments received over five years and any potential capital gain or loss if the bond is called back.
Significance of Bonds and Bond Yields
Bonds serve as vital investment tools for individuals and institutions alike. They provide a steady stream of income through interest payments and are generally considered less risky than stocks. Understanding bond yields helps investors assess the potential returns and risks associated with different bonds.