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Investing in bonds can be quite tricky as you will need a good handle on many financial concepts such as yield, maturity date, face value, yield to maturity and cash to be paid at the time of maturity. Thankfully, the Internet is full of websites that will give you free access to a bond calculator, that will make the calculations for you.
But, even to use a bond calculator, you will need to understand the basic concepts that are applied by the bond calculator.
How does a bond calculator work? Elements used for calculation in a bond calculator
Yield% – This element is used to describe the income that is earned on an investment. The yield % is usually an indicator of dividend or interest that is received from a particular investment type. In the case of bonds, yield % refers to the interest rate.
This is how the yield on a bond is calculated. Let us take an example where a bond is bought at $1,000 par value, at a 10% coupon rate. In this case, the bond yield is simply calculated as $100/$1,000. Now, let us assume that the price of the bond drops to just $800. In this case, the bond yield will go up to 12.5%. On the other hand, if the price of the bond goes up to $1,200, the bond yield will drop to a figure just over 8%.
Yield to maturity – This is another very important factor that is used in a bond calculator. The example mentioned above is a very simple one. However, yield to maturity will require a more complex calculation. When calculating yield to maturity, it is assumed that the investor will hold the bond until the day it matures. So, it is also assumed that any interest earned on the bond is reinvested back into the same bond. In essence, yield to maturity is like applying compound interest to the investment while the above mentioned example is a simple depiction of how simple interest would be applied in a bond calculator. The yield to maturity will also include any profits or gain that the investor made, by buying the bond at a discount, if they did.
Calculating yield to maturity is not something that the general public will be able to do, or at least successfully do. This is where a bond calculator will be very handy as it will spit out what you need quite easily.
How is bond price and yield linked to one another by a bond calculator?
In general, bond price and yield are inversely linked to one another. In other words, if the price of a bond falls, the yield will increase. If the yield decreases, the price of the bond will increase. The price of a bond is also linked to the interest rates that are available in the market. If the interest rates of the economy increase, the price of the bonds will fall and lead to an increase in yield. On the other hand, when interest rates decrease, the price of the bond will increase and the bond yield will reduce.