I recently wrote a blog about achieving decent short-term returns with debentures and bonds. However, as I revisited my own writing before publishing, it dawned on me that while explaining financial terms like "coupon" and "yield," I had unintentionally crafted a mini-textbook. Back when I encountered these terms during my student days, I struggled to appreciate them fully due to their lack of real-world examples. Post my MBA, my professional roles never demanded the application of these concepts either. I occasionally dabbled in the markets, yet it wasn't until a few years ago that I truly delved into appreciating these concepts.
With that in mind, here is Part I of those pesky financial terms... focussing on interest rate and returns related terminology. These only apply to debt instruments such as Government Securities, Non Convertible Debentures and Corporate Bonds.
🌟 Face Value: The face value of a bond or an NCD is like its starting price. It's the amount the bond is worth when it's first made. This value stays the same until the bond matures, which is when it finishes its time. When the bond matures, the holder gets back this face value. This value is used to figure out how much interest the bondholder gets every year, which is called the coupon payment. In India, most bonds (not all) are issued at a Face Value of ₹1,000 when common investors are expected to participate.
🌟 Coupon Rate: Think of the coupon rate as the bond's interest promise. In this case, with a coupon rate of 8%, the company pledges to pay you 8% of the bond's face value annually. That's ₹80 (8% of ₹1,000) coming your way every year. Depending on the terms, NCDs offer interest payment frequency as monthly, quarterly, semi-annually, annually, and cumulative; The last option basically means the coupon payment is added back to the principal and is reinvested - very similar to the cumulative FD options that banks offer.
🌟 Yield: Yield is the return you receive on the bond, usually expressed as a percentage. It considers not only the coupon payments but also any changes in the bond's market price. Since bonds are also traded in the secondary market in India now, just like equity shares, this is the right metric for measuring return when you buy NCDs/bonds from there. If you want to understand how bond pricing works, that is a different blog post altogether, so I will skip that for now.
For example, if you buy the above bond (with a face value of ₹1,000 and a coupon rate of 8%) at ₹950 from the secondary market, your annual interest of ₹80 relative to your investment of ₹950 gives you a yield of about 8.42%. It's like a sneak peek at your potential earnings considering the investment's current price.
If the bond's market price rises above its face value, the yield can be lower than the coupon rate, and vice versa. This gives you a more accurate picture of the actual earnings from the investment.
🌟 Yield to Maturity: Yield to maturity is the annualized return made when the NCD/bond is held till it matures. It takes into account the redemption value also. So in the same example above, even though you bought the bond at ₹950, you will get ₹1,000 back when you redeem the bond, along with the interest on the bond. Let's assume you hold onto it until its 5-year maturity. At the end of those 5 years, you'll get the face value of ₹1,000 plus your annual ₹80 coupon payments. This translates to a "yield to maturity" of 9.1%.
Whether I buy to hold a bond till it matures or to resell, I prefer looking at Yield to Maturity since it also accounts for any loss or profit I will make on redemption.
That concludes the first post on simplifying financial terms... Hopefully this helped and will make some of my other posts easier to read.