How to Calculate Bond Interest Rates
Bonds are a type of debt security, which, in practice, can be thought of as a loan. With a bond, the issuer is the borrower, who enters into a debt agreement with the holder (the creditor). The debt on a bond can be represented in a variety of ways, depending upon the terms of the bond contract. Debt can be paid by interest (called the "coupon" or "coupon rate") from issuer to holder, and/or by repayment of the principal at some later time (referred to as "maturity"). Bond interest rates depend on many factors, but a few calculations can provide workable estimates for decision-making purposes.
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Instructions
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Identify Bond Features
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Find the bond's face value. Also known as the nominal or principal, the face value is the money amount on which the bond issuer pays interest. In many bonds, face value has to be repaid at maturity. The face amount may not be the same dollar value as the "issue price," the sale price at which the creditor gets the bond from the issuer.
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Locate the coupon rate. The coupon is the interest rate to be charged against the face value, and the issuer must pay this interest to bond holders. Also locate the maturity date, or the day when the debt agreement is over and the issuer has to repay the face amount. Not all bonds stipulate repayment at maturity.
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Examine other bond features. Because bonds are unique contracts between two parties, they can include a variety of terms and stipulations. The recurring interest payments from issuer to creditor can be monthly, quarterly, semi-annually or annually. Most bonds in the U.S. are semi-annual, meaning that they pay a coupon every six months. The bond also may have other, more complex arrangements. Simple interest rate calculations will not take into account some of these features, despite their impact on the bond's value.
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Find the relevant price of the bond. Bonds are not always issued or exchanged at face value (known as "at par"). When the bond price is lower than the face value, the bond is "discounted"; when it is higher than face value, the bond is "premium."
Calculating the Interest Rate
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Be specific about which interest rates you want to know about. The coupon rate is the interest rate on the face amount but doesn't reflect a real interest rate because of changes in bond price. The bond's "current yield" is the earned interest rate per year. Often, you may not want to know about the year-to-year performance, but rather total-investment performance. The most useful statistic may be "yield-to-maturity," which represents the interest rate earned on the total investment throughout the term of the bond, including any repayment of principal at maturity.
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Apply formulas. Current yield is equal to the annual interest payment made divided by the price of the bond, but this calculation doesn't provide a very good estimate for the real interest rate. An approximation of the yield-to-maturity can tell us the interest rate more firmly. Yield-to-maturity is equal to: [(annual interest payment)+(face value - current bond price)/(number of years until maturity)] / [(face value +current bond price)/2].
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Calculate yield-to-maturity more accurately with this sigma formula: B= n sigma k=1 (I)/(1+Y)^k + P/ ((1+Y)^n, where B=current bond price, I=coupon rate of interest, P=face value, n=number of years until maturity, Y=yield-to-maturity and the word "sigma" represents the sigma symbol. This formula is more difficult to work with but is more along the lines of how calculators do these computations.
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Tips & Warnings
Bond calculations can be complex, and calculators can really make things easier. Graphing calculators may offer applications that can solve time-value of money problems (such as calculating bond interest rates).
These calculations do not take into account the issuer's credit-worthiness. When an issuer fails to pay back interest because of financial problems (bankruptcy, for example), the real rate of return will be lower or even negative.
