Bonds from scratch: where the return comes from

A bondholder's return is made up of the coupons the issuer pays on schedule; of the difference between the price at which you bought the bond and the amount you received at redemption or on sale; and of what you did with the coupons already received — spent them or reinvested them. Tax and transaction costs are deducted from that sum. Everything else written about bonds is a refinement of these components: which of them is fixed in advance, which depends on the market and which depends entirely on your own decisions.

The coupon: the only part the issuer promises

A coupon is a debt payment fixed in the terms of the issue. For a fixed-coupon bond, both the size of the payment and the calendar are known: the rate does not change until redemption. For a bond with a variable or floating coupon, what is fixed is not the size but the rule — a link to the key rate, to a money-market rate or to inflation. The difference is fundamental: in the first case you know the cash flow, in the second you know only the formula by which it will be calculated.

The coupon accrues every day; it does not come into being on the payment date. That is why, when you buy, you pay the seller the accrued interest — the part of the current coupon that has already built up by the trade date. Accrued interest is not lost and is not an entry fee: it comes back to you in full inside the next payment. But it explains why the amount debited is larger than the price you saw in the order book — see the distinction between the clean price and the dirty price.

Price: the component most often forgotten

A bond is redeemed at par but trades at the market price. Buy below par, and a gain at redemption is added to the coupons; buy above par, and part of the coupons goes to make up for the premium you paid. This is where the gap between the "coupon rate" and the actual result lives: the rate is written into the prospectus once and for all, while the price is recalculated by the market continuously, adjusting the resulting yield to the current level of interest rates.

This is also the source of the main risk of selling early. If you exit a bond before redemption, you receive the market price instead of par — and that price may have fallen as rates rose. The further away the redemption, the greater the sensitivity to such a rise: the mechanism is explained in the piece on duration. For a bond you hold to maturity, price fluctuations are noise; for a bond you may sell ahead of time, they are a fully fledged source of profit or loss.

Reinvestment: the component you create yourself

A coupon arrives as cash in your account and then does nothing on its own. If you spend it, your return is the sum of the payments plus the price difference. If you reinvest it, the income from investing the coupons is added, and the outcome depends on the rates prevailing at the moment of each such investment — it is not known in advance. This is reinvestment risk: the calculated yield to maturity silently assumes that all coupons are reinvested at the same rate, and the market gives no such guarantee. That is why total return is measured after the fact, not from the prospectus.

When par does not stand still

There are issues where the calculation base itself changes. With amortisation, the issuer repays par in instalments according to a schedule — the coupon accrues on the outstanding balance, so the payments shrink over time, while the money comes back before maturity and has to be placed again. For bonds with an indexed par value, par is recalculated for inflation, and the bulk of the result comes not through the coupon but through the growth of the base. For replacement bonds, par and coupon are pegged to a foreign currency while settlement is in roubles, and currency revaluation is added to the components.

What is deducted

The coupon is taxed; the tax is, as a rule, withheld by the broker, and the tax base for investment income is determined by the rule 13%. Tax changes not only the final result but the very choice between bonds with similar yields — this is covered in detail in the analysis of the tax on coupons. Then come the costs: the broker's and the exchange's commission, the spread between the buying and the selling price, and, for thinly traded issues, the price of an urgent exit as well. For a short bond these deductions are noticeable against a small coupon stream; for a long one they are diluted by the term.

How to bring it together in one calculation

Assemble the components in the same order in which they arise. Step one: how much money actually leaves the account — the clean price plus accrued interest plus commission. Step two: what cash flow is promised — the coupons on schedule and the repayment of par, adjusted for amortisation or indexation. Step three: what will remain of that flow after tax. Step four: what you do with the coupons. And only after that compare issues with one another — and with alternatives such as a deposit, which works differently.

Why the same investment is described by several different yields, and why brokers' figures do not match, is a separate story, covered here. The credit risk premium, that is, the extra yield for the fact that the payer is not the state, is dealt with in the analysis of OFZ and corporate issues; its extreme case is high-yield bonds. Specific values for individual bonds are deliberately not given in this piece: they live in the list of bonds and on the page of each issue, where they are updated along with the market.