How To Calculate How Much Money You Will Make On A Bond By Bill Dufrane

If youre going to play the market, youre likely in it to win. You expect a modest return on your investment, or at least to make your money back. Your choice of investment matters a lot, so it really helps if you can calculate how much money you can expect to make. The most general meaning of yield is the amount of money returned (usually annually) in the form of dividends.

Within finance, a bond is a debt security, in which the issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon). Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bond holder, or limitations on the behavior of the issuer. Bonds are generally issued for a fixed term (the maturity) longer than one year.

A bond is just a loan, but in the form of a security, although terminology used is rather different. The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Bonds enable the issuer to finance long-term investments with external funds.

1. Current Yeild

If you are looking to estimate the amount of money you stand to gain, the procedure is really quite simple. Divide the annual interest amount paid by the current market price. CY = IAP*100. (The 100 turns the fraction into a percentage.) For example, a $1000 face-value (par) bond with a coupon (interest rate) of 7% that matures in 10 years may sell currently at a discount for $950.

2. Holding Your Bond To Maturity

You will gain the most money in dividends if you hold your bond to maturity. Would you rather have $1000 today or $1000 a year from now, even assuming youre assured of getting paid in a year? Having $1000 sooner rather than later means earning interest on that $1000 for an additional year!

3. Years To Maturity

YTM is the best number to use when comparing bonds with different rates and maturity dates. With a little practice, the process becomes familiar and loses the aura of numerology. Profits go to the fearless. Here's the formula...

c(1 + YTM)-1 + c(1 + YTM)-2 +. .. + c(1 + YTM)-YUM + B(1 + YTM)-YUM = P

c = annual coupon payment (in dollars, not a percentage)
YUM = number of years until maturity
B = par value (original issue price)
P = purchase price

Resource: http://www.isnare.com/?aid=92777&ca=Finances