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How your Fixed Income Bond’s Return is affected?

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Bonds provide stability and diversification to your portfolio. A bond provides a regular income. A bond is also a better substitute for fixed deposits as it provides better returns and is also more tax-efficient due to indexation benefits. A bondholder receives a regular income through a bond’s coupon payment. There are various factors that affect these coupon payments and the principal value of the bond. Before understanding the factors which affect a bond’s return, let us understand what are the sources of return by investing in a fixed income instrument/bond: 


Sources of Income from a Bond:

  1. Bond’s coupon and principal payments on the scheduled dates, 


  1. Return generated out of reinvestment of coupon payments, and 


  1. When a bond is sold before its maturity, the potential capital gains or losses.

When a bond is purchased at a premium or a discount, it adds another aspect to the rate of return. 


Factors affecting the bond’s return: 

There are many factors that affect fixed-rate bond returns. Here are the main factors:

  1. Credit Risk or Default Risk


  1. Interest Rate Risk 

Credit Risk/Default Risk: The credit risk is the most important of all the risk factors affecting the bond’s return. Credit risk means whether the bond issuer will be able to make the full payment of all the interest/coupon and principal on the scheduled time. A good credit rating for a bond will give assurance of timely repayment of the bond’s coupon and face value. A corporate bond’s coupon is higher than the government bonds. 

Interest Rate Risk: Assuming no default (No credit risk), the bond’s return is also affected by interest rate changes. As a bond issuer pays a regular coupon/interest as per the bonds’ term, these coupon/interest payments are reinvested. Any change in the interest rate is going to affect the future value of these invested coupon amounts. Also, a change in interest rate is also going to affect the future value of the bond’s proceeds if the bond is sold before its maturity.

Bond’s Price and the change in Interest Rate: A bond’s price is inversely related to the change in interest rate. If there is an increase in interest rate, the bond’s price will fall and if there is a decrease in the interest rate, the bond’s price will increase. 

How the change in interest rate is going to affect the bond’s price may be measured using ‘Duration’; a duration estimates the price change of a bond for a given change in interest rates. 

Interest Rate Risk differs as per the investment horizon: Investors who hold the same bond may have different interest rate risk exposures if their investment horizons differ. 

Every bond investor is affected by two offsetting types of interest rate risk: 


  1. Coupon reinvestment risk: The future value of reinvested coupon payments increases when interest rates rise and decreases when rates fall as the coupon amount is invested at a high/low-interest rate, respectively. Coupon reinvestment risk matters more when the investor has a long-term horizon relative to the time-to-maturity of the bond. 


  1. Market price risk: In a portfolio, the principal on bonds that mature before the horizon date, has to be invested till the remaining horizon period. If the interest rate falls, the future value of this invested amount will be less and if the interest rate rises, the future value will increase. In the same way, the sale price of a bond whose maturity is more than the investment horizon period of an investor has to be sold before the maturity period of the bond. This bond’s value decreases when interest rates rise and the bond’s value increases when rates fall as the value of the bond is being estimated using the interest rate as a discount rate. 


How is the Interest Rate, Yield to Maturity, and Realized Yield related to a bond?

Interest Rate: Interest rates are the rates at which coupon payments are reinvested. The interest rate is also used as market discount rates to discount the future cash flows (Coupon and principal value) of the bond. This discounting is done to estimate the bond’s value at the time of purchase or at the time of sale if the bond is not held to maturity.

Yield to Maturity: The yield/return (Internal rate of return) anticipated on a bond if the bond is held till maturity. At the time of purchase, the yield-to-maturity measures the investor’s rate of return under three assumptions: 

  1. The investor holds the bond to maturity, 


  1. There is no default by the issuer, and 


  1. The coupon interest payments are reinvested at that same rate of interest.

Realized horizon Yield: The realized horizon yield is the actual yield (Internal Rate of Return) generated on a bond during the holding period. The realized horizon yield matches the original yield-to-maturity if: 

  1. The coupon payments are reinvested at the same interest rate as the original yield-to-maturity, and 


  1. When the investor sells the bond, there are no capital gains or losses.