Bonds are a form of debt financing, in which investors loan money to borrowers at a specified interest rate over a period of time. The borrower will pay interest on the loan each year, and when the bond reaches maturity, he will also pay the investor back the face value of the bond. While many people understand how simple interest works, it can be more difficult to understand compound interest, which is basically interest paid on unpaid simple interest. Using this method of calculation, investors will earn a higher return over time.
Gather information about your bonds. You will need to know the face value of the bond, the interest rate, and how long the issuing period is (example: 10 years). Using this data, you will be able to calculate compound interest.
Understand the formula for compound interest, which is C=FV+(1+R)^N. Here, C represents compound interest, FV represents the face value of the bond, R is the interest rate, and N is the time period over which the bond is paying interest. This is the standard formula for bonds that compound interest annually.
Evaluate whether interest is compounded annually or in some other manner. Most bonds involve interest that is calculated annually, but some may be calculated monthly or quarterly. If the interest is not compounded annually, you will need to modify the formula in Step 2 so that the value for R equals the interest rate divided by the number of times it is compounded annually. You will also need to modify N so that it is equal to the number of years multiplied by the number of times the interest is compounded each year.
Use the formula in Step 2 to calculate the compound interest. For example, if we have a $10,000 bond that pays 5 percent interest, compounded annually, over 10 years, the compound interest would equal $10,000+(1.08)^10, or $6,286.
Determine the effective rate of return. To do so, use the following formula: Effective Rate of Return = [ (Face Value + Compound Interest) - Face Value ] / Face Value. In our example above, this would be: Effective Rate of Return = [ ($10,000 + $6,286) - $10,000 ] / $10,000. Here, the effective rate of return would be 62.9 percent. Use this effective rate of return to evaluate the strength of the investment.