The company issues bonds to run its business. The government issues bonds to finance projects, such as toll roads. Bond issuers are debtors and bond investors are creditors. Investors receive interest income each year and a return on the face value of the bonds at maturity. In addition to interest income, investors can also earn profits through the sale of bonds. If the sale of the bond results in a loss, the loss will reduce the investor's total return. Your total return is tax-adjustable and the present value of the investor's cash inflows.
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Part 1 of 3: Calculating Interest Earned Bonds
Step 1. Confirm the interest rate and face amount of the bonds
Most bonds charge a fixed interest rate (called the coupon rate). This interest rate can be different from the market interest rate. Regardless of the type of bond, you should know the nominal interest rate on the bond certificate.
- Most bonds are now issued in the form of a journal entry. When you purchase bonds, you will receive documentation of the bonds you purchased. Instead of receiving a physical certificate of ownership, you receive a third-party document, which verifies ownership of the bond. This document states the interest rate and nominal amount of the bonds purchased.
- Bond interest income is based on the face value of the bond certificate. The face value will be multiplied by IDR 1,000. Multiply the nominal interest rate by the face value of the bond.
- Assume that you buy a bond worth $10,000,000 with an interest rate of 6%. Since the interest rate is fixed, meaning that the bond will pay out Rp600,000 annually (Rp10,000,000*0.06). Interest payments are fixed even if the bond price in the market fluctuates.
- The premium or discount on bonds refers to the selling price of the bonds. Premiums and discounts are compensation for investors against the difference between the nominal interest rate on the bond and the current market interest rate. If the current market interest rate is higher than the nominal interest rate, the bond is sold at a discount. If the current market interest rate is lower than the nominal interest rate, the bond is sold at a premium.
Step 2. Add the total interest income from the bonds
Interest income is part of the total return of the bond over the life of the bond. Verify the number of years of bond ownership and then calculate the interest income each year.
- Use the accrual accounting method to calculate interest income. The accrual method recognizes interest income at the time of acquisition. If you hold bonds for several months of the year, interest income is recognized only in those months of ownership.
- The accrual method is not related to cash payments received. Interest income is based on bond holdings, not on the interest payment date.
- Most companies pay interest twice a year. For example, your bond interest payment dates are February 1 and August 1 each year. You calculate interest income for the month of December. Since you hold the bond for the full month of December, you are entitled to receive interest payments in that month. You receive full interest income in December, even though interest is not paid until February 1 of the following year.
Step 3. Determine the interest income earned after the sale of the bonds
Like stocks, bonds can be bought and sold by fellow investors. As an investor, you can hold bonds until maturity, or sell them before maturity. You can sell bonds on weekdays.
- If you sell a bond, the sale has an impact on the total interest income received. For example, bonds pay interest on February 1 and August 1 each year. You sell the bonds on December 15.
- To calculate the total return, you need to know the total interest income over the life of the bond.
- Let's say the face value of the bond is $10,000,000 with a fixed nominal interest rate of 6%. The bonds pay out Rp600,000 annually. If the bonds are held for 5 full years, the total interest income is CU600,000*5 years = CU3,000,000.
- You also need to calculate the division of interest for the year. In this case, you have a bond from January 1 to December 15. The shareholding period is 11 of the 12 months of the year. The interest income during the year is [(Rp600,000*(11, 5/12) = Rp575,000].
- You are entitled to receive interest income during the term of ownership even if interest is only paid months later.
- The total interest income for 5 years and 11 months is (Rp 3,000,000 + Rp 575,000 = Rp 3,575,000).
- The total return formula may involve the exact number of days on which the bond is held. The number of days bond ownership is based on 360 days in a year. The number of days depends on the bond issuer (government business entity or company).
Part 2 of 3: Calculating Capital Gain or Loss
Step 1. Record the initial purchase price of your bonds
The capital gain or loss is part of the total return on the bond. If you sell the bond above the purchase price, you make a profit. If the bond sells below the purchase price, you incur a loss. To calculate a capital gain or loss, you need to know the purchase price of the bond.
- When bonds are issued, the bonds are first sold from the issuing company (or government entity) to the public. Investors buy bonds, and issuers get cash on the sale of bonds.
- If you buy a bond when it's issued, you usually pay the face price of the bond. The face value of the bonds is IDR 1,000,000 or multiples thereof. For example, if you buy a bond with a face value of $10,000,000 when issued, the cash paid out is $10,000,000.
- Bonds can be bought and sold between investors when they are issued to the public. For example, Bambang bought Telkom bonds when they were first issued. Bambang paid cash in the amount of Rp. 10,000,000. Bambang can choose to sell the bonds at any time until the bonds mature. The selling price of the bonds owned can be more or less than Rp. 10,000,000.
- Note that capital gains are considered income and are taxed. So you have to pay taxes on the interest earned.
Step 2. Sell the bonds at a discount
Discount means that the selling price of the bond is less than its face value. For example, a bond worth $10,000,000 could have a market price of $9,800. The market indicates that investors are not willing to pay Rp. 10,000,000 for the bonds.
- Bonds are valued at a discount if the bond's nominal interest rate is lower than the new bond's nominal interest rate. In comparison, consider buying newly issued bonds by the same issuer and having the same maturity.
- For example, Telkom has outstanding bonds worth Rp. 10,000,000 and an interest rate of 6%. Bonds mature in 10 years. Interest rates have increased. Investors can buy Telkom bonds with an interest rate of 7% and a maturity of 10 years. Bonds bearing a 6% interest rate are now lower in value, because the interest income received is less than bonds with a 7% interest rate. The market price of the bonds will fall below IDR 10,000,000.
- If an investor buys a bond for Rp. 10,000,000 and sells it for Rp. 9,800,000, the investor suffers a capital loss of Rp. 200,000. Capital losses reduce the total return on bonds.
Step 3. Sell the bonds at a premium
Premium means the price of the bond above its face value. For example, a $10,000,000 bond has a market price of $10,100,000. The market indicates that investors are willing to pay bonds more than their face value.
- Bonds are valued at a premium if the nominal interest rate on the bonds is higher than the interest rate on the newly issued bonds. Compare your bonds with newly issued bonds by the same issuer with the same maturity.
- For example, Telkom has outstanding bonds worth Rp. 10,000,000 and an interest rate of 6%. Bonds mature in 10 years. Interest rates have decreased. Investors can now buy Telkom bonds with an interest rate of 5% and a maturity of 10 years. Bonds bearing a 6% interest rate are now higher in value, because the interest income received is more than bonds with a 5% interest rate. The market price of the bonds will rise above IDR 10,000,000.
- If an investor buys a bond worth IDR 10,000,000 and sells it for IDR 10,100,000, the investor earns a capital gain of IDR 100,000. This gain increases the total return on the bond.
- Capital gains and losses can occur if bonds are sold and purchased before their maturity date. Investors can also buy bonds at a premium or discount and hold them until maturity. In each case, you may experience a gain or a loss.
Part 3 of 3: Determining the Total Return of the Bond
Step 1. Add the total income from the bonds
You can calculate the total return by adding the bond's interest income to the resulting gain or loss. The gain or loss is generated based on the sale of the bond, or holding the bond to maturity.
- For example, you buy bonds with a face value of IDR 10,000,000. You hold the bond to maturity and receive a principal amount of Rp10,000,000. There is no gain or loss on the bonds. The bonds pay 6% interest and the bonds are held for 5 years and 11 months.
- The number 11 from 12 months in the last year can be changed to 0.958. The total interest income received to maturity is [(Rp10,000,000) X (6%) X (5,958 years) = Rp3,575,000]. The total return on the bonds is the interest income earned (Rp3,575,000).
- Let's say you buy the same bonds and hold them to the same maturity. However, bonds with a face value of Rp. 10,000,000 are sold at a price of Rp. 9,800,000. You incur a loss of IDR 200,000. The total return on the bonds is (interest Rp3,575,000) - (capital loss Rp200,000) = Rp3,375,000.
- Let's say you buy the same bonds and hold them to the same maturity. However, bonds with a face value of Rp. 10,000,000 are sold at a price of Rp. 10,100,000. You experience a profit of IDR 100,000. The total return on the bonds is (interest Rp3,575,000) - (capital gain Rp100,000) = Rp3,675,000.
Step 2. Adjust the total return of the bond for the tax effect
Interest income and capital gains and losses will be taxed. You have to consider the amount of income after withholding taxes.
- Assume interest income and capital gains total $3,675,000. You pay a final 15% Income Tax (PPh) on interest income and capital gains.
- The total return after tax is IDR 3,675,000 X 85% = IDR 3,123,750.
- Interest income is subject to final tax. That is, interest income tax expense should not be recognized as an expense and reduce profit.
- The tax rate imposed on interest income and capital gains on bonds is the same, namely 15% final income tax
- Please note that in certain countries you can record capital losses to reduce taxes. You can use investment losses to reduce capital gains. That way, the amount of tax you have to pay will be reduced. For example in the US, if your losses outweigh the gains, you can reduce your income by up to $3,000 in one tax year. Meanwhile, if your loss is more than $3,000, you can claim $3,000 in the following year, and so on until it is completely deducted.
Step 3. Calculate the effect of market interest rates on bond prices
The selling price of bonds varies depending on market interest rates at the time. If the current market interest rate is higher than the nominal interest rate, the bonds are sold at a discount. Conversely, if the current market interest rate is lower than the nominal interest rate, the bonds are sold at a premium.
- For example, let's say a company sells bonds for $500,000, 5 years, 10 percent, but the current market interest rate is 12%. Logically, you wouldn't want to invest in bonds that return 10% if current market interest rates were higher (12%). Therefore, the company discounts the price of the bond to compensate you for the difference in interest rates. In this example, the company will sell bonds at a price of Rp.463,202,000.
- On the other hand, let's say the market interest rate is 8%. Thus, a nominal interest rate of 10% is a better return from the market. The company knows this so it increases the selling price of the bonds and issues them at a premium. The company will issue bonds worth Rp500,000,000 at a price of Rp540,573,000.
- In both cases, you still receive interest payments based on the face value and interest rate of the bond. The bond's annual interest income is $50,000,000 (Rp500,000,000 * 0.10).
- When the bond matures, you receive a return amounting to the face value of the bond. Even if bonds are purchased at a premium or discount, the return at maturity remains at par. For example, in the previous example the return received on the due date was $500,000,000.
Step 4. Understand the difference between yield and interest rate
Yield or yield is the total return of the principal of the bond. Yield is influenced by market interest rates because market interest rates affect the selling price of bonds, but yields are different from nominal interest rates and market interest rates.
- Calculate the yield using the bond face value/price formula.
- Based on the example above, the company issues IDR 500,000,000 bonds, 5 years, 10%, and a market interest rate of 12%. The Company sold the bonds at a discounted price of Rp.463,202,000.
- The annual bond payment is IDR 50,000,000.
- Annual yield is IDR 50,000,000 / IDR 463,202,000 = 10.79%.
- In the example when the market interest rate is 8%, the bonds are selling at a premium, and the price is $540,573,000.
- Annual yield is IDR 50,000,000 / IDR 540,573,000 = 9.25%.
