In the previous article on Bonds – Part 1, we discussed the basics of Bonds and some important terms related to bonds. We also mentioned that 2 revenue source of bonds returns are
- Interest income (YTM)
- Mark to market gains/loses (MTM) – Due to bond price change
Today we will discuss more about these two sources in detail. Three main key concepts to understand about Bonds return are Coupons, Yield and Yield to maturity.
Coupon – Committed or fixed return that the bond holder expects to receive at regular intervals until maturity as a percentage of the face value
Yield – Yield is the return that you get on the bond. It may or may not be equal to the coupon. Bond yield depends on the bond price change.
“Market interest rate and Bond price are inversely related” which means when the market's interest rate goes up, the bond in your hand goes less attractive compared to the bond available in the market with a higher interest rate and so the price of your bond goes down and vice versa.
When the investor holds a Bond of face value Rs.100, Coupon 10% and tenure of 10 years.
When the Market rate is at 10%, bond price remains the same i.e Rs.100.
Yield = coupon / Bond price = 10/100 = 10%
When the Market rate moves up to 11%, the bond price will be reduced to Rs.90.
Yield = coupon / Bond price = 10/90 = 11.11%
When the Market rate moves down to 9% and the bond price will move up, say Rs.110.
Yield = coupon / Bond price = 10/110 = 9%
Coupon of the holding bond is unchanged but the yield differs due to price change of the bond in the market which is in turn due to Market interest rate.
“Bond price and Bond yield have inverse relationship”
Yield To Maturity (YTM) – Yield to maturity is different from yield. When the Coupon received is REINVESTED at the market rate without spending then YTM comes to picture. The return we get after reinvesting all coupons received till maturity is known as Yield to maturity.
YTM is used for the instruments which we intend to hold till maturity (HTM).It is the total return after considering the compounding effect of the reinvested coupon amount.
How does the tenure of the bond affect the bond price?
Considering the same example mentioned above (10% coupon on bond 100Rs Face value with 10 years Tenure), When the market rate increases to 11% and when you want to sell the bond before maturity, the price of the bond tends to fall.
In other words, if I buy the bond from you, I will be getting only Rs.10 as Coupon compared to the bonds available in the current market which is giving a coupon of Rs.11 for the bond worth the same Rs.100.
To compensate for the loss of Rs.1 per year , I will be willing to buy the bond from you only for Rs.90.
If the tenure is for 20 years, then the price will be discounted more to compensate Rs.1 loss for the tenure of 20 years which will be Rs.80.
Thus the 20 year bond has more loss compared to 10 year bond price when the interest rate increases. This is also applicable even when the market interest rate is reduced. The gain due to price change is more for a bond with a 20 years tenure compared to a 10 years tenure bond. This price change is all about Mark to market (MTM).
YTM (Yield to Maturity) and the Risks involved in bonds :
YTM depends on the risk of the bond. The yield increases as the risk increases. What kind of risks are we taking when we buy a bond?
- Time Risk
One of the risks is the amount of time we chose to invest our money by buying a bond. We are more uncertain of the factors that influence the bond price when we invest for a longer duration, therefore those who buy the bond for a longer period of time expect more reward to compensate for the risk he/she is taking. Therefore, bonds with longer tenure have slightly more risk and more yield.
- Credit Risk
The other risk is credit risk. When a government issues T-bill, the risk will be less compared to a private company issuing bond. Because it is less likely that a government will default, whereas a private company has more risk of getting defaulted. Therefore, the buyer takes more risk when the bond is issued by the private company and would expect to have more return/reward for the risk he/she is taking. A bond return also depends on the credit rating of the bond. Lower the risk of default, higher the rating, therefore higher the return and vice versa.
In summary we have discussed the following points.
- Two sources of income from bonds which is interest income and the other one is due to bond price change.
- Difference between coupon, yield and yield to maturity.
- Yield to maturity is the yield of the bond after considering the compounding effect of reinvesting the coupon amount.
- Income from the bonds depends on two types of risk that is time risk and credit risk
- Due to the above mentioned risk of the bond and change in the interest rate, the bond price changes. This source of income due to bond price change is mark to market (MTM). In other words, Marking the price of the bond based on the current market rate.
Now kindly let me know in the comments section if you are interested to understand about a concept called duration of the bonds which helps us understand bonds sensitivity to the market rate change or how much the bond price changes due to market rate change.