When investors purchase a bond, they buy the right to receive interest from the company that issued the bond. The interest rate on a bond is calculated by taking into account the risk of default by the company. However, calculating the investment return on a bond is not always so straightforward.
Certificates of deposit, annuities and the bond market all share commonalities in being fixed-income investment instruments. This means that owners expect a predictable rate of return for their investments and any compound interest. Treasury bonds and some corporate bonds are considered to be relatively safe investments.
Is the Bond Market Risk-Free?
Bonds are essentially loans and borrowers may be the U.S. government or corporations. Bonds are debt instruments, unlike stocks, which are regarded as units of ownership. The face value of a bond is the bond’s future value after reaching its maturity date. Face value is also known as the par value.
While bond investing is often regarded as less risky than other investments, bonds are not risk-free, per FINRA. Bonds can run the risk of exposure to specific types of risk, specifically inflation risk, liquidity risk and credit risk. These risks can expose investors to substantial losses if they assume there will be a positive rate of return.
Relying solely on a bond’s purchase price plus the number of years a bond matures at its stated interest rate can introduce risks for bondholders. Understanding bond value relative to the market interest rate can help manage those risks. The market interest rate influences bond valuations based on things like global crises or speculation about inflation.
Why Consider the Market Interest Rate?
Inflation risk is a major concern when interest rates go up. This is because the rate of interest might not keep up with the cost of inflation, reducing its overall value. The market price of a bond is determined using a discount rate. A discount rate is the difference between the current market price and the face value of a bond.
If the market value of a bond drops, then it cannot be sold or liquidated quickly. This is known as liquidity risk. Next, credit risk is the potential that a bond issuer or insurance company will not be able to cover the face value of the bond. This is a common risk associated with “junk bonds,” which are high-yield but also at high risk for default.
Key bond calculations include the coupon rate or nominal yield, the current yield and the yield to maturity or YTM. These are all ways to calculate bond yields. Pure discount bonds, or zero coupon bonds, are simplest to calculate because they do not offer periodic interest payments known as coupon payments and they feature two cash flows: the purchase price and face value.
How to Calculate Bond Interest?
The coupon rate is the annual interest payment divided by the face value. If a $1,000 face bond pays $10 each year, then the bond’s coupon rate is 1 percent. This is the simplest calculation of the three because these numbers are fixed.
A bond’s current yield is what an investor would earn by holding the bond for another year. It is the annual interest paid divided by the present value of the bond. If a bond pays out $10 annually and is currently valued at $500, the current yield is 2 percent.
The bond yield to maturity is the more common calculation of the three. It accounts for the purchase price of the bond, present value, future value and bond maturity. This calculation examines the return on a bond from purchase to maturity; it is not the coupon rate. If you want to try the calculation by hand, the yield to maturity formula is as follows:
YTM = [C + (FV-PV/t)] / [(FV+PV)/2], where C is the interest, FV is the face value, PV is the present value and t is the number of years until maturity
The YTM calculation is complex because it requires trial and error for exact numbers, according to the Corporate Finance Institute. It can be done more quickly and accurately using the Excel Solver Function. The software can solve the YTM using the present value.
Hashaw Elkins is a financial services and tax professional, as well as a project management consultant. She has led projects across multiple industries and sectors, ranging from the Fortune Global 500 to international nongovernmental organizations. Hashaw holds an MBA in Real Estate and an MSci in Project Management. She is further certified in organizational change management, diversity management, and cross-cultural mediation.