How to Calculate Rates of Return on Your Bond Investments
Bond investing can be tricky business indeed — way trickier than stock investing. To help explain why, let’s look at some Babylonian friends, Nabu-usabsi and Nabu-sar-ashesu. And let’s also introduce two new characters, Lila-Ir-lender and Kudur-Broker. The two Nabus are real characters from a bygone era. Lila-Ir-lender (said to be a distant cousin of Hammurabi) is fictional. Kudur-Broker is also fictional.
Lila-Ir-lender, like Nabu-sar-ashesu, is a moneylender. Kudur-Broker is, appropriately enough, a broker. Instead of dealing only in minas and shekels and agreements written on parchment, assume the existence of bonds. With lenders, borrowers, and a broker, that makes a complete bond market!
Okay, are you ready to see why this bond business can be so tricky? Good. Let’s return to ancient Babylonia!
Instead of merely signing an agreement, suppose that Nabu-usabsi, in return for lending his half mina of silver to Nabu-sar-ashesu, gets a bond. Nabu-sar-ashesu’s bond clearly states that Nabu-usabsi will get his investment back in one year, plus 331⁄3 percent interest. In the parlance of the bond world, the bond is issued with a face value of a half mina of silver, a coupon rate (or interest rate) of 331⁄3 percent, and a maturity (or expiration date) of one year.
Measuring bond returns is not always an easy matter. Why not? After all, the agreement calls for 331⁄3 percent interest. Simple enough, eh? Not really.
Suppose that Nabu-usabsi wants to get his 331⁄3 percent interest not as a lump sum at the end of the year but in two installments (as most bonds work): 162⁄3 percent after six months, and another 162⁄3 percent after another six months. That is obviously a better deal for Nabu-usabsi because he gets 162⁄3 percent of his investment back sooner and can, if he wishes, reinvest that money for another six months.
Suppose that, in fact, he is able to reinvest that money for a very high interest rate. By the end of the year, Nabu-usabsi will actually earn more than 331⁄3 percent on his original investment. But how is his real rate of return calculated?
To complicate matters further, suppose that Nabu-sar-ashesu, the bond issuer, has agreed that his bond can be sold, and that he will continue to pay 331⁄3 percent interest to whomever buys the bond. In walks Lila-Ir-lender, who wants to buy the bond from Nabu-usabsi but uses Kudur-Broker, the bond broker, to make the deal.
Kudur-Broker pays Nabu-usabsi one-half pound of silver to obtain the bond. Eager to buy himself a new camel, Kudur-Broker turns around and sells it to Lila-Ir-lender for one pound of silver and pockets the difference for himself.
Lila-Ir-lender is now the proud owner of a bond that is paying 331⁄3 percent on the original face value (one-half pound of silver). She, however, paid much more for the bond, thanks to the bond broker’s handsome markup. So even though she is holding a bond that is paying 331⁄3 percent, she isn’t really getting 331⁄3 percent on her money; she’s getting a significant amount less.
Now how much is the true rate of return on the bond? Is it 331⁄3 percent, or is it 162⁄3 percent, which is the actual percentage return that Lila-Ir-lender would be getting on the money she laid out?
Embracing the complications
You see why this bond business can be so confusing? (Yes, it would be just as confusing if the names were Mike and Sue instead of Nabu-usabsi and Nabu-sar-ashesu!)
Bond investments can confuse even many financial professionals. How much do you really need to know? It depends.
If you are okay investing in bond mutual funds and you’re going to buy and hold your investment, then a cursory knowledge of what makes bonds tick is probably just fine. (Knowing how they fit into a well-diversified portfolio is probably more important.) If you are intent, however, on dealing in individual bonds or trying to flip bonds to make a profit (good luck!), you’d better either know this stuff or find a bond broker you can really trust.
Understanding what follows is easier than finding a bond broker you can really trust. Trust us.