The average rate of return of any bond is the average loss or gain bondholders make over a specified period relative to the cost of their investment. Typically, it is calculated annually and is expressed as a percentage. CNN reports that government bonds have an average rate of return of 5 percent to 6 percent, compared to stock market returns, which are higher and average 10 percent.
Bonds: An Introduction for Beginners
While many novice investors understand the basics of the stock market or mutual funds, many have an understanding of the bond market that’s hazy at best. It’s understandable, as the price of a bond doesn’t follow conventional wisdom that governs pricing across the rest of the market, and financial publications focus less coverage on bond trading than on stocks and other investments.
Because of this, many beginners in the bond market hunt for bonds with returns above the average for the bond market. It’s a wise strategy, but flawed: Because of the dozens of different types of bonds and the way their market purchase price impacts their yield but not their posted rate, it’s impractical – not to mention largely irrelevant – to describe the average rate of return across all bonds on the market.
What Is a Bond?
A bond is essentially a loan from an investor or bondholders to a government agency or a corporation. Examples include municipal bonds and U.S. savings bonds. An investor purchases a bond for face value – $1,000 for example. In return, he receives periodic interest payments as described by the bond’s coupon rate of, for example, 6 percent.
In this case, the investor receives $60 annually for the life of the bond. When it matures at a date determined when it was originally issued, the borrowing party repays the initial purchase price to the investor and the interest payments cease.
How Maturity and Rating Affect a Bond’s Price
Several factors influence the rate when borrowers issue the bond, with long-term bonds typically paying higher than short-term bonds, and less risky investments, such as government or Treasury bonds, paying lower than those rated as higher risk, such as corporate bonds. Finally, the prevailing interest rate at the bond’s issue date also affects its return.
What About Zero-Coupon Bonds?
Whereas many bonds pay bondholders interest regularly until their maturity date, zero-coupon bonds don’t. According to Investor.gov, these bonds are sold at a steep discount. And instead, at maturity, the investor will receive the par value of the bond. Some people refer to zero-coupon bonds as zero-interest bonds.
After-Issue Sales and Pricing of Bonds
Things become much less straightforward once investors begin trading bonds on the secondary market. Because bonds pay a constant return, their price on the open market is linked to changes in the prevailing interest rate.
Continuing the example above, if the average interest rate increases to 7 percent, investors aren’t willing to purchase a bond with a substandard 6 percent return rate. Consequently, the market price of the bond falls to approximate prevailing rates so investors receive a 7 percent return on the purchase. Because of this, the bond would sell for $857, the price at which its $60 interest payment would be a 7 percent yield.
Bond Yield and Price Quotes
While bond return rates are defined when they’re issued, traders use a measure – yield – to determine its real-world returns based upon the price paid for the bond. Traders express a price as a figure that represents a percentage of its face value.
For example, the bond issued for $1,000 and purchased for $857 would be listed at a price of 85.7. Its yield, calculated by dividing its purchase price by its dollar-value rate of return, is 7 percent. These price and return rates vary daily because of interest rate changes and other market factors but are typically different from when the bond was issued.
Types of Bonds and Return Rates
The length of time to a bond's maturity, as well as the bond issuer’s bond credit rating and the industry in which it works, also impacts the bond’s price. Because of this, it’s difficult to determine the average price of all bonds. In addition, this price fluctuates daily based on market values.
According to CNN Money, five-year U.S. Treasury bonds typically pay yields about half of those of 10-year bonds, and 30-year bonds’ average yield is about 50 percent higher than those of 10-year bonds. Investment-grade corporate bonds pay a slightly higher yield than 30-year Treasury bonds.
Formula for Calculating a Bond’s Rate of Return
According to FINRA, you can calculate a bond’s total rate of return as follows:
Total Rate of Return (RoR) = (((End value of principal + Coupon interest + Compound interest) - (Taxes+ Fees/Commission) – (Beginning value of principal))/Beginning Value of Principal)) * 100%
Finding the Annual Rate for a Specific Investment You’re Considering
If the period is more than one year, you should divide the total return by the number of years you have factored in to get the average annual interest rate.
Annual RoR = Total Rate of Return/Number of Years Factored.
For example, if you have a bond with a 15 percent rate of return over 5 years, your annual rate of return would be:
Annual RoR = 15/5 = 3 percent.
On the other hand, if you need to get the annual average rate of return across multiple bonds, you can add up all the annual rates of return for each bond and divide by the number of bonds.
So, if you had three bonds, the formula would look like this:
Average rate of return of all bonds = ((Annual RoR_1+Annual RoR_2+Annual RoR_3)/3)
What Is the Average Rate of Return Used For?
The average rate of return is used to determine the profitability of bondholders’ investments over a specified period of time. Also, you can use it to determine the average cash flow over the life of the bond. You can then determine whether it’s worthwhile for you to continue keeping the bond beyond its holding period, depending on whether the fixed income it offers meets your financial requirements. You might also considering looking into other metrics like the yield to maturity (YTM) or internal rate of return (IRR) for investments.
This article was written by PocketSense staff. If you have any questions, please reach out to us on our contact us page.