Simple math terms for fixed coupon corporate bonds
Bonds, in general, are simply debt instruments that allow companies, or the government, to finance their capital needs by finding investors who are willing to lend them an amount in return for interest for a period, before repaying. the principal amount of the loan in full. . There are specific rates and periods on which the bond issuer and investor agree.
While the numbers may seem confusing at first, breaking down the important numbers and a few simple calculations can help make the calculations behind corporate bonds a little easier to understand. Especially when it comes to determining which corporate bonds are worth investing in and which don’t offer a high enough return on investment (ROI).
Key points to remember
- Calculating bonds may seem difficult, but it is necessary to calculate the value, risk and return of a bond.
- Before calculating the metrics of a bond, there are several pieces of terminology that need to be understood and disambiguated.
- Here, we’ll go over the basic mathematical terms of bonds, including coupon, duration, and yield to maturity.
Definitions of some important terms
Current yield: This is the current yield on a corporate bond based specifically on its market price and nominal interest rate, rather than its face or face value (see below). This yield is determined by taking the bond’s annual interest and dividing that amount by its current market price. To make this clear, let’s consider this simple example: a $ 1,000 bond that sells for $ 900 and pays a coupon of 7% (i.e. $ 70 per year) would have a current yield of 7, 77%. This is $ 70 (annual interest) divided by $ 900 (current price).
Yield to call: Call yield refers to the yield of the bond if it is redeemed on the earliest possible call date instead of its maturity date. The date used in this calculation is usually the earliest possible call date, not the final date when it reaches its full value. It is not uncommon for prudent investors to determine both the yield on a corporate bond to be repurchased and the yield to maturity before making a final decision on investing in a bond. A range of possible returns becomes evident with the callable return on the low end. While the yield to maturity is used to determine the possible high end yield of the bond.
Yield to maturity (YTM): This is the interest rate to equate the price of a bond with its current cash flow value. When the sentence gives way at maturity is used, this means that it is assumed that the corporate bond will be held to maturity. In addition, this term also assumes that all intermediate cash flows are reinvested at a rate equivalent to the yield to maturity. If the corporate bond is not held to maturity, or if the cash flows are reinvested at rates different from the rate of return to maturity, the investor’s return will be different from the return to maturity. deadline. It is important to note that the calculation of the yield to maturity takes into account any capital losses, gains or income that investors experience when they hold a bond to maturity.
Worst return (YTW): This is the lowest possible return that a corporate bond can generate. This measure is usually called before maturity.
Duration: It measures the sensitivity of a bond to changes in interest rates. Duration specifically refers to the weighted average length of time it takes for a security’s cash flows to mature. This average duration is weighted specifically by the percentage of the present value of the cash flows over the price of the security. This means that the longer or longer the term of a bond, the more vulnerable it is to changes in interest rates. According to Blackrock, as a rule of thumb, for every 1% increase or decrease in interest rates, the price of a bond will change by about 1% in the opposite direction for each year of term.
Other factors to consider
Due date: The maturity date is the date on which you receive your main investment in a corporate bond. It therefore also determines how long you will receive interest payments on that principal. Of course, there are a few exceptions to the way it works. For example, some bonds or securities are considered redeemable. This means that the bond issuer can repay the principal at specific times before the actual maturity. Undoubtedly, it is important for investors to determine whether a corporate bond is callable before investing in such securities.
Coupon: This is the annual amount of interest paid by a bond and is often expressed as a percentage of the face value of the bond. This means that a $ 1,000 corporate bond with a fixed coupon of 6% pays $ 60 per year for the life of the bond. Most interest payments are made semi-annually. So, in this example, investors will likely receive a payment of $ 30, twice a year. As mentioned above, there is also a current yield which can deviate from the coupon, which is also called nominal yield as opposed to the current yield. This is because bonds, once issued, can be traded and resold, which can cause their value to fluctuate. It is important to keep in mind that changes in the current yield do not affect the coupon as face value, and annual payments are set from the date of issue.
Nominal value: This is the nominal value of the bond, that is to say the amount entered in the corporate charter of the issuer. This amount is particularly important for fixed income bonds where it is used to determine the value of the bond at maturity as well as the number of coupon payments up to that date. The normal face value of a bond is $ 100 or $ 1,000. The current market price of any corporate bond may be higher or lower than face value at any time depending on many different factors such as the current interest rate, the credit rating of the bond issuer , the quality of the company and the duration to maturity.
The current price (or purchase price): This is only the amount an investor pays for the corporate bond (or any other security). For investors, this is the important amount because the current price ultimately determines their potential return on investment. If the purchase price is much higher than the face value, then the opportunity probably does not present as great a possibility of return.
Frequency of coupons and date of interest payment: It is important that all investors know the frequency of coupons as well as the exact dates of payment of interest on the corporate bonds they hold in their portfolio. This information can be found for example in the prospectus of the issuer.
The bottom line
Using the information mentioned above, investors can accurately determine the cash flows generated by the interest payments of different corporate bonds. As noted, most corporate bonds pay semi-annually; however, the alternatives are annual or quarterly: a corporate bond (annual coupon frequency) with a face value of $ 1,000 and a 6% fixed coupon pays $ 60 once a year on the predetermined interest payment date .
A corporate bond (quarterly coupon frequency) with a face value of $ 1,000 and a fixed coupon of 6% pays $ 15 four times a year, also on predetermined interest payment dates. Indeed, by bringing together the relevant data for all the corporate bonds in a portfolio, investors can obtain a clear distribution structure for their portfolio as they receive precise information on the date and amount of each interest coupon. that they will receive. By making the sum accordingly, the investor will be able to determine for example the exact amount of the monthly interest received. These are great methods for discovering important numbers.