When investors in India decide to buy bonds they quickly realise that coupon rate is not the full story. The number that really helps compare different bonds is bond yield. Once you know how to calculate bond yield step by step the whole bond market starts to look less confusing and more logical.
What bond yield really shows
In simple words bond yield is the return you earn on a bond based on the price you pay today.
Coupon is calculated on face value. Yield is calculated on your actual purchase price. If the bond trades below face value your yield is higher than the coupon. If it trades above face value your yield is lower.
When you invest in bonds yield becomes the common yardstick. It lets you compare bonds with different coupons prices and maturities on one clear scale.
Step by step example to calculate bond yield
Take a very typical Indian example.
Face value of the bond is one thousand rupees
Coupon rate is eight percent per year
So coupon amount is eighty rupees per year
Remaining maturity is five years
Current market price is nine hundred fifty rupees
We will look at two ideas
- Current yield
- An approximate yield to maturity
Step one
Find the annual coupon
This part is easy.
Coupon rate eight percent applied on face value one thousand gives
Eighty rupees interest every year
This is the fixed cash flow you will receive each year till maturity as long as the issuer pays on time.
Step two
Calculate current yield
Current yield looks only at one year of interest and the price you pay today.
Formula in words
Current yield equals
Annual coupon income
divided by
Current market price
So in our example
Current yield equals eighty divided by nine hundred fifty
Do the maths.
Eighty divided by nine hundred fifty is zero point zero eight four two.
As a percentage that is about eight point four two percent.
Notice what happened. Coupon is eight percent but because you are buying at a discount to face value your current yield is a bit higher.
Step three
Approximate yield to maturity
Yield to maturity or YTM is the return you would earn if you hold the bond till it matures receive all coupons on time and get face value back at the end. It includes
All yearly coupons
Plus the gain you make because you bought below face value
The exact YTM needs a financial calculator but there is a simple approximation that works quite well for plain bonds.
Approximate YTM equals
Annual coupon income plus Difference between face value and current price divided by remaining years
All of this divided by
Average of face value and current price
Now plug in the numbers.
Difference between face value and price is
One thousand minus nine hundred fifty equals fifty rupees
Spread this over five years
Fifty divided by five equals ten rupees per year
Add this to the yearly coupon
Eighty plus ten equals ninety rupees
Now find the average of face value and price
One thousand plus nine hundred fifty equals one thousand nine hundred fifty
Divide by two
Average equals nine hundred seventy five rupees
Now divide yearly return by this average value
Ninety divided by nine hundred seventy five is about zero point zero nine two three
As a percentage that is roughly nine point two three percent
So your approximate yield to maturity is just above nine point two percent per year.
This tells you that if you buy this bond today hold it for five years and the issuer pays everything on time you can expect a return close to nine point two percent each year on average.
How to use this when you buy bonds
Knowing how to calculate bond yield helps in three ways.
First you can compare options. Two bonds may both have eight percent coupon but if one trades at a big discount its YTM may be much higher. Yield reveals that hidden difference.
Second you can judge whether the extra yield is worth the extra risk. If one bond from a weaker issuer shows a much higher yield you can pause and ask whether the credit risk justifies that extra return.
Third you can read interest rate signals. When overall yields in the market move up prices of existing fixed coupon bonds fall. When yields move down prices rise. Watching bond yield is like watching the pulse of the bond market.
Once you get comfortable with this simple example you can apply the same logic to any plain bond you see. That way every time you invest in bonds you are making a clear yield based decision rather than guessing from coupon rates alone.
