Many investors view bonds as a way to diversify their portfolio outside of the stock market because they are viewed as more stable than stocks. However, as interest rates change, and the creditworthiness of the bond issuers fluctuates, the price you must pay to purchase the bond can change.
As a result, you might not always be receiving the annual interest rate stated on the bond, and based on its original face value. Knowing how to calculate the annual rate of return allows you to accurately determine whether the return you receive is worth the risk.
TL;DR (Too Long; Didn't Read)
To calculate the annual rate of return on a bond, divide the interest paid, if listed, each year by the purchase price.
Calculating the Annual Rate of Return
Bonds typically list an interest rate as a term of the bonds. If the bond lists the interest payment rather than the rate, divide the interest paid each year by the purchase price to calculate the interest rate paid each year. For example, if you have a bond that pays $50 of interest on a bond selling for $1,000, divide $50 by $1,000 to get 0.05, or a 5-percent annual rate of return.
Multiple Years Until Maturity
When you have a bond that won’t return the principal for a number of years, you have to include a portion of the additional principal to the return each year to calculate the true annual rate of return on the bond. To do so, determine the size of the discount you received or premium you paid by subtracting the purchase price from the face value. Then, divide the premium or discount by how many annual payments you will receive before the bond matures. Third, add the interest paid per year to the result. Next, divide the total by the average of the price you paid for the bond and the face value. Last, multiply the result by 100 to calculate the effective annual interest rate.
For example, say you purchase a $1,000 bond that will make annual 5-percent interest payments for 20 years before returning the principal for $1,010. Subtract $1,010 from $1,000 to get negative $10, meaning you paid a $10 premium. Then, divide the negative $10 by the 20 years of payments to get negative $0.50. Third, add the $50 interest payment per year to the negative $0.50 to get $49.50. Next, divide $49.50 by $1,005, the average of $1,010 and $1,000, to get 0.0493. Finally, multiply 0.0493 by 100 to find your annual rate of return on the bond will be 4.93 percent.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."