09^th January, 2021 by elmads

One of the reason for investing our hard-earned money is to gain additional wealth from our initial capital to achieve our own required return. The problem that arises is that how will we know if the investment we take will be enough to attain our required rate of return? This is the reason why valuations have been coined and created. It is a method of determining the price of an asset and the estimation of the worth of something, in this case, bonds.

Finding what will be the return on our bond investment, before buying it is very important because what we want is the best possible return we can achieve to attain our financial objectives. It is now time to move to a bit of advancement into our bond asset class topic. We are now going deeper, on how we will know if the bond that we are planning to purchase will grant us a return that we want and attain an equal, if not higher to inflation.

As I briefly discussed in by blog titled “Bonds”, I cited that there are 2 ways where we gain money from it. First is through coupon payments that we receive either quarterly, bi-annually or annually, and is based on the par value and interest payment of the bond. And secondly, to buy and sell bonds. Both investment return methods by context are same as stocks.

Bonds can have both simple and compound interest returns. If you are not familiar with these two, I have tackled it in details in my blog titled “Simple & Compound Interest”.

Before I move forward with the strategies. I just want to point out that below is an example of a bond, in which we will base our computation for the various strategies of valuing a bond. This will be the bond example that I will be using all throughout this blog.

The Strategies

1.) Simple Interest Strategy – under this are two further strategies which are based on coupon yield and current yield.

Coupon Yield – This is the common strategy in which investors will purchase the bond, then they receive the coupon payment and hold it up until the bond matures. In here, we will not sell the bond in the market at all.

Coupon yield is automatically stated in the bond itself, in case of our example above, the yield is 3%. This translates to 300 GBP interest payment income annually.

We will continue to receive 300 per year up until the end of the term, which is 10 years in the case of our example. In short, what is indicated in the coupon rate of the bond is the automatic return that we will be receiving in a yearly basis up until the bond matures.

Current Yield – In this process, we buy the bond from the market. Note that, we did not buy it first hand meaning, the first investor bought the bond directly from the issuer in the specific date of issue, then sold it in the market after a month or a few years of holding that bond. Henceforth, the term of the bond has been reduced already. See sample below.

Moving forward, Just like in the stock market, bonds Par Value fluctuates in price. In the example, that 10,000 value of the bonds can either be worth more or less than the initial price it was sold since it was issued by the banks who made it. This is because of certain factors like the Central bank interest rates, the political status of the country where the bonds were issued, or problems in the company if it is a corporate bond. Nonetheless, the price we pay for that certain bond will dictate if our yield/return will be higher or lower depending on the bond’s Coupon payment per year.

The yields/returns that investors get from bonds are predictable and consistent, as it is indicated already on the bond contract. Unlike in the stock market, the yields/returns are unpredictable because company’s dividends are dependent in their general business performance. In addition, the bonds interest payment per year does not change even if it is already traded in the bond market.

In that note, we expect that our interest payment in our example will still be 300 GBP per year (10,000 x 3%). The next question is which will have a better return for us? is it when the the bond price is selling higher than the original Par value of the bond? or when the bond price is selling at a lower price? It is definitely when the the market price is lower than the Par value of the bond.

As depicted in the visual example above, the important data to know are the Coupon payment per year (this is always constant as it is computed and can be found in the bond itself), and how much the bond is currently trading for. As you have noticed the lower the price the bond is trading in the bond market the better the yield we will be receiving upon purchasing it, whereas when we buy at a higher price our yield will be lower. This also holds true with stock market investing.

The downside of the Current Yield is that it only considers what the annual coupon payment is. The total cash that we will be receiving in the future and the Par value return after the bond matures is not considered in the formula.

2.) Compound Interest Strategy through yield to maturity – Yield to maturity, also known as redemption yield or book yield. It is a process in which bond investors reinvest the coupon they receive and will receive into another bond to compound their gains. As much as possible the income we receive should be reinvested to another bond with the same coupon rate from the first bond that we have. For instance, if the current bond we hold has a coupon rate of 3% then we should find another bond with the same coupon rate of 3% to reinvest the coupon payments we received from our current bond. It is compounding the coupon payments at 3% return yearly. It is actually not mandatory to reinvest it with bonds of the same rate, the only reason why it is advised to do so, is because computing it at the same rate makes yield to maturity result more accurate, precise and easier, unlike having various coupon yields.

In addition, Yield To Maturity (YTM) is the anticipated total return on a bond until it is held to maturity and it also takes into account the Par value that we will receive once the term contract expires. The formula and computation are as follows:

The example I used is the same government bond sample that we have been using in this article. As illustrated, the computation is complex but it takes into account all the characteristics of a bond, namely the coupon payment, Par/Face Value, Number of years before it matures and the Price we payed for it. Due to reinvesting our Coupon payment, the amount that we can achieve can always be higher. Reinvesting is the key component here, placing the money we earn from our investment back in either the same or other investment instrument can make our hard-earned money grow more. It is literally money working for us to make more money. I know that you are intrigued what will happen if we pay more than the value so I’ll show it to you based again on the same bond sample

Note: if you want the excel spreed sheet computation. I can send it to your email. Just DM me or you can email me your email address.

To sum it up

Bonds have been with our society for more than 5 centuries already. It has proven time and time again how important it is not only to us investors, but also to the people as a whole. It is a debt instrument that helps the governments and companies to spur growth of our economy through constructions, making additional jobs, and innovations to improve lives of the people. Knowing what returns we need will greatly help us to choose what bonds to purchase based on the computations and valuation methods mentioned in this article. Nevertheless, it does not warrant that all investors must invest in bonds, what is important here is that we find ways in which we will feel comfortable in accumulating wealth. Just like any other objective and aims in our lives, everything boils down on our personality and how we approach matters in our own way to achieve our own goals.

Knowledge is my Sword and Patience is my Shield,

Evan Louise Madriñan / elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.