There is no maturity date or fixed interest payment in stocks which makes stock market risky. In contrast bond funds pays interest on the funds and they have fixed maturity date. Considering other fixed income securities (likes Treasury bonds, Money Markets, Certificate of Deposits, etc.) Bond funds usually give you high yield fixed income.
Let us understand basic concepts on Bond Funds:
A bond is an interest certificate, issued by either private companies (known as corporate bonds) or by government agencies (known as Treasury Bonds, State Bonds, Government Bonds, etc.). Bonds pay a fixed interest on maturity date you can redeem or sell prior to maturity as well. Government bonds have no risk of defaulter, while corporate bonds carry the risk of defaulter on interest, principal, or both.
Coupon rate is the interest rate per annum. For example, If bond par value is Rs.1000/- and coupon rate is 15 percent that means you get Rs.150 interest per annum.
2. Current Yield:
Bonds price keep on fluctuating in secondary market. For example, If bond par value is Rs.1000/-, and coupon rate of 15 percent and current market price of Rs.700/- that means bond has a current yield of 21% (Rs.150 / Rs.700). This is because any fluctuation in price doesn’t affect the interest payment (i.e.. Rs.150/-) upon maturity.
3. Yield to Maturity:
It is a disposable return expected at the maturity of the bond. For example, Assume you buy ICICI Prudential Plan at Rs.1000/- par value with a 9% coupon (interest) rate maturing in 5 years, and the market price for the bond is Rs.800/-. The coupon rate is the annual interest rate payable on par value that is 9% on Rs.1000/- which is Rs.90/-. The current yield of the bond is the interest divided by the current price of the bond, which in this case is Rs.90 / Rs.800, or 11.25%. On redemption after 5 years you realize Rs.200 as capital gain since you have purchased bond on discount at par value and yield to maturity value is 14.90%.
Taking above scenario now let us understand how to calculate yield to maturity value:
|Calculation of Yield to Maturity Value|
|Interest rate||9%||Coupon Rate of the Bond|
|Par value||1,000.00||Par Value of Bond|
|Purchase price||800.00||Current Market Value of Bond|
|Capital gain||200.00||Discount Gain = Rs.1000 – Rs.200|
|Number of years to maturity||5||Maturity of Bond|
|Annualized capital gain (A)||40.00||Capital Gain (Rs.200) / No. of Years (5)|
|Annual interest (B)||90.00||Par Value (Rs.1000) * Coupon Rate (9%)|
|Total annualized return (C = A+ B)||130.00||Total Gain per year on Bond|
|Yield “D”||16.25%||Purchase Price (Rs.800) / Annual Return (Rs.130)|
|Yield “E”||13.54%||Annual Gain (Rs.130) / [ Par Value (Rs.1000) – Annual Capital Gain (Rs.40) ]|
|Yield to Maturity||14.90%||[ (Yield D + Yield E) / 2 ] i.e.. Average of D and E is the Yield to Maturity value|
Let us take the example to understand when and how to invest in Bond funds.
Bond price is inversely proportional to Interest rate. When interest rate fall by 3-4 percent then bond price will gradually increase by 3-4 percent. Let us take the simple example to understand this concept. Assuming bond is issued at par value Rs.1000/- and coupon rate is 10 percent paying Rs.100/- per annum. Now let us assume that interest rate increased by 20 percent paying 12 percent as a new coupon rate which looks quite attractive for investors. Now your bond price will decrease by 20 percent respectively, New calculated current yield price will be Rs.833/- (Rs.100 / 12%) which is equally incredible for the investors.
This tutorial lesson gives you the understanding that Bonds are best investment in fixed income category when interest rates are high and about the fall so that investors make profit from both sides of the coin that means high income with high interest rate and principal gain when the interest rates start decreasing. Vice versa Bonds are poor fixed income investment when interest rates are low and about to increase, giving investor principal loss with increase in interest rate if decided to sell off before maturity or bond term ends.