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Bond Investment: The Difference Between Interest And Yield

  • When investing in bonds, investors shouldn't just look at the coupon. Because the respective return always depends on the term and the bond price.
The bond markets have gone on a rapid roller coaster ride in the past few weeks. Take a ten-year federal bond, for example: on March 9, the yield hit a record low of minus 0.91 percent. When the extent of the economic damage in the course of the corona crisis became apparent, the nimbus as a "safe haven" for German government bonds was gone for the time being. Investors withdrew their money, prices fell and the yield rose to minus 0.15 percent within just ten days.
Some may now ask: Why do rising yields have to do with falling prices? The reason for this is that bonds - in contrast to stocks - are bonds and the price reflects the current value of the receivable.

How the price affects the return

The yield on a bond should not be confused with the coupon (nominal interest). Because the former changes constantly due to price fluctuations, since bonds are usually traded on the stock exchange and the buying or selling price and the term have a significant effect on the return.
The market value of a bond is not expressed in euros, but as a percentage of the nominal value - also known as the nominal value. In the case of federal bonds, the nominal value per bond is 100 euros. The bond subscriber has to pay this amount to the issuer - in this case to the state of Germany.
If, for example, the paper rises by five percent after the issue, the price is quoted at 105 percent. The paper has a value of 105 euros - without taking the coupon into account. If the subscriber were to sell the paper again at this point in time, the price gain would be five percent.
The next buyer, in turn, has to put five euros more than face value on the table. Since the issuer's redemption price at the end of the term is always the nominal value, the buyer can only offset his higher stake with the annual interest payments, unless he sells the paper again at a higher price. However, there is of course the risk of falling prices.
Investors should therefore not be blinded by the amount of the coupon, but should always take the price into account. For example, if the nominal interest rate on a bond is 3.5 percent and the purchase price is 105 percent, the investor only receives a current interest rate of 3.33 percent per year on the capital invested.
The calculation is as follows: (Interest rate x 100) / market value = current interest. With a purchase price of 95 percent, the current interest rate in the example would be 3.68 percent.

Note the holding period and selling price

But none of this says anything about the actual return or the effective interest rate. Because here, in addition to the purchase price and nominal interest rate, the repayment price and the term of the investment are also included.
Back to our example: With a purchase price of 105 percent and a nominal interest rate of 3.5 percent, the investor decides to sell the paper after two years at a price of 130 percent. This brings the return or the effective interest rate to 15.24 percent. Without taking transaction costs into account.
The formula for this is: {Nominal interest + [(selling price - buying price) / term]} / buying price x 100 = yield.
If, however, the investor could only sell his bond at a price of 99 percent after two years, the effective rate of return would only be 0.48 percent per year.



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