Gilts and bonds

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9. Calculating the redemption yield

The aim of the redemption yield is to show the total return on a bond if held to its maturity date. The total return will include two components:

1. All the interest payments which you receive until maturity
2. The amount which will be paid back to you on maturity.

Both of these have to be calculated separately, and then expressed as a single percentage. City bond analysts use complex mathematical models to get the figure exactly right. For most investors a simplified version will do.

Assume that you are about to buy a £100 bond which matures in 2013 and has a coupon of 5%. Its current price is discounted to £93, and you want to know what the redemption yield is. You need to do two calculations:

Step 1 - Calculate the current yield on income

This is the same calculation you performed two pages previously. Just divide the annual income by the market price, and multiply by 100. On the figures above:

5 / £93 x 100 = 5.38%

So your current yield on income is 5.38% - higher than the coupon of 5%, which is as it should be, because you bought at a discount to nominal value.

Current yield on income calculator Annual income   % Current price of bond       Yield:    %

Step 2 - Calculate the current yield on capital gain/loss

Divide the actual amount of discount or premium by the number of years the bond has left to run. In this case the discount is £7 (£100 minus £93), and the number of years left is 5. The average annual gain per £100 of stock is therefore £1.4. Divide this figure by the current price of the bond (£93) and multiply by 100 to get the annual gain in percentage terms:

£1.4 / £93 x 100 = 1.51%

Current yield on capital gain/loss calculator Discount     Remaining years     Current price of bond       Yield:    %

Step 3 - Add the two yields together

Add the current yield on income (5.38%) to the current yield on gains (1.51%) and you have the redemption yield 6.89%.

What does it mean? It means that on this investment, even though the coupon is 5%, your total return if you hold the bond to maturity will actually be 6.89%.

Note that if you buy a bond at a premium, the calculation will be the same, except that the current yield on gain will be a negative figure which you subtract from the current yield on income. And the outcome will be a redemption yield which is lower than the coupon figure.

1. What are bonds? 2. Different types of issuer 3. Different types of bond 4. Bonds compared to shares 5. Bonds as tradeable instruments 6. Nominal yield 7. Calculation of current yield 8. Capital gains on gilts and bonds 9. Calculating the redemption yield 10. Factors which affect bond prices 11. Are bonds for you? 12. Selecting gilts and bonds 13. How to buy gilts and bonds 14. Unit trusts and bond funds 15. Keeping track of your bond investments 16. Tax 17. Conclusion

• First Steps in Bonds
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• Pricing Convertible Bonds