- How to Calculate a Bond's Current Yield
- Understanding the Coupon Rate
- Zero Coupon Bond (Definition, Formula, Examples, Calculations)
- How to Calculate a Bond's Current Yield
- Zero-Coupon-Bond Yield
How to Calculate a Bond's Current Yield
Zero coupon bonds do not pay interest throughout their term. Interest is compounded semi-annually throughout the duration, or at the end of each fraction of a half-year for any fractional years remaining. The above formula is the one we use in our calculator to calculate the discount to face value every half-year throughout the duration of the bond's term. Subtract 1, and you have 0. Most bonds typically pay out a coupon every six months. Thus if interest rates fall, any outstanding bond which pays an interest rate above the current prevailing rate enjoys capital appreciation, since it is paying a higher rate than an investor could obtain by buying another similar bond at current rates.
Since zero coupon bonds do not pay a coupon, any capital appreciation remains in the bond. Since they sell at a discount to their stated maturation value they are known as discount bonds.
Understanding the Coupon Rate
In a falling rate envirnoment zero-coupon bonds appreciate much faster than other bonds which have periodic coupon payments. I started investing in 30 Year zero coupon treasuries. Now, zero coupon bonds don't pay any interest, but they are issued at a discount. And the interest in effect is in effect built in the difference between the issue price which is below and they're expiring at It's built-in.
Now, the fact that it's built-in, it has big advantages when interest rates come down. You don't have a reinvestment risk. In other words, if you invest it, let's just take an example. But the zero coupons build that in, so you get actually about twice as much appreciation for given declining interest rates with a zero coupon, as with a coupon bond, and the longer the maturity, the more bang for the buck.
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- Should I Invest in Zero Coupon Bonds?;
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- Bond Yield Vs the Coupon Rate.
Now, it works both ways. You'll lose more money if rates go up. But actually, I started in with the zero coupon bonds from my own account in And by the mids, the Shilling family, on that one investment, had achieved financial independence.
Well, I've never, never, never bought Treasury bonds for yield. I couldn't care less what the yield is as long as it's going down. Because when it goes down, they increase in price, and I bought it for the same reason most people buy stocks. Most people don't buy stocks for dividends, you have some for utilities and real estate investments, but most people are looking for appreciation.
And that's what my interest is in Treasury bonds.
Zero Coupon Bond (Definition, Formula, Examples, Calculations)
That difference in price is capital appreciation. The first disadvantage is they do not throw off any income as the capital is stored in the bond. In some countries the imputed interest may be taxed as income even though the bond has not yet been redeemed or reached maturity. The IRS requires zero-coupon bond holders to pay tax on the "phantom" imputed interest income just as they would if they had received coupon payments, even though there wasn't any interest paid to the bond holder.
For the subsequent years you would start with the base from prior years to calculate the new imputed interest value. The second major disadvantage is when interest rates rise significantly they can see a drastic decline in capital value, as they have a significant duration risk because no capital is paid out until the bond reaches maturity risk remains embedded in the instrument until it is redeemed.
We try to find assets that have the best combination of risk and return. In this section we will see how to calculate the rate of return on a bond investment. If you are comfortable using the TVM keys, then this will be a simple task. We will discuss each of these in turn below. In the bond valuation tutorial, we used an example bond that we will use again here.
How to Calculate a Bond's Current Yield
For the sake of simplicity, we will assume that the current market price of the bond is the same as the value. You should be aware that intrinsic value and market price are two different, though related, concepts. The current yield is a measure of the income provided by the bond as a percentage of the current price:. There is no built-in function to calculate the current yield, so you must use this formula. For the example bond, the current yield is 8. Note that the current yield only takes into account the expected interest payments.
It completely ignores expected price changes capital gains or losses.
Zero-Coupon-Bond Yield
Therefore, it is a useful return measure primarily for those who are most concerned with earning income from their portfolio. It is not a good measure of return for those looking for capital gains. Furthermore, the current yield is a useless statistic for zero-coupon bonds. Unlike the current yield, the yield to maturity YTM measures both current income and expected capital gains or losses. The YTM is the internal rate of return of the bond, so it measures the expected compound average annual rate of return if the bond is purchased at the current market price and is held to maturity.
In the case of our example bond, the current yield understates the total expected return for the bond. As we saw in the bond valuation tutorial , bonds selling at a discount to their face value must increase in price as the maturity date approaches. The YTM takes into account both the interest income and this capital gain over the life of the bond.
There is no formula that can be used to calculate the exact yield to maturity for a bond except for trivial cases. Instead, the calculation must be done on a trial-and-error basis. This can be tedious to do by hand. Fortunately, the BAII Plus has the time value of money keys, which can do the calculation quite easily. Technically, you could also use the IRR function, but there is no need to do that when the TVM keys are easier and will give the same answer. Enter 6 into N , But wait a minute!