A bond works in much the same way as a loan. The borrower, which can be either a government agency or a corporate entity, issues a bond. The bond buyer serves as a lender, allowing the bond issuer to use the funds from the bond purchase in return for a later repayment with interest. Since most bond purchasers buy the bond for a different price than its face value, the expected return on a bond will vary with the purchase price.
Par Value and Bond Maturity
The par value of the bond is the face value on that bond. Most corporate bonds have a par value of $1,000. This means that the bond purchaser is entitled to $1,000 when the bond reaches maturity. The maturity date is the date the bond expires, which is also the date the bond issuer must repay the bond buyer. For example, Fictional Fashion, Inc., issues bonds with a par value of $1,000 and a maturity date of January 1, 2020.
Bond Markets and Bond Pricing
While bonds are worth their par value when the issuer first releases them, these bonds can also go on sale in a secondary market, known as a bond market. Investors buy bonds from brokers, rather than the issuer. The secondary buyer may either sell the bond back in the bond market for a profit, or wait until the bond matures. Prices in the bond market can fluctuate due to movements in interest rates, changes in the bond issuer's credit rating or shifts in the general economy.
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Calculating the Expected Return
The expected return on a bond can be expressed with this formula:
RETe = (F-P)/P
Where RETe is the expected rate of return,
F = the bond's face (or par) value, and
P = the bond's purchase price.
The larger the difference between the face value and the purchase price, the higher the expected rate of return.
For instance, Generic Investments purchases a $1,000 bond issued by Fictional Fashion for $900 in the bond market. The expected return on the Fictional Fashion bond is:
= 100/900 = 0.1111 = 11.11 percent.
As the bond markets fluctuate, Pretend Partners purchases a $1,000 Fictional Fashion bond for $800. The expected return for Pretend Partners is:
= 200/800 = 0.25 = 25 percent.
Uses for Expected Return
Investors can use the expected return on bonds to determine the optimal amount they can expect to receive on a bond. In some cases, such as with government bonds, the expected return gives an accurate estimate of the return the investor can hope to receive. The more reliable the credit history of the bond issuer is, the more reliable the estimate of the expected return will be. However, high-risk bonds may not deliver on the expected return, due to default or bankruptcy.