Income from bonds

The yield of a bond depends primarily on the nominal interest paid. If, in addition to the regular interest payments, the remaining term, the purchase price and the redemption price are taken into account, you obtain the effective interest rate of a bond, known as the yield. This yield can be calculated continuously. If investors intend to sell a bond on the stock market before the end of its term, the yield is determined not only by the nominal interest rate but also by the price development.

Investors receive regular interest payments on their bond, unless it is a zero coupon bond. These payments are evidenced by interest coupons. Interest on a bond is referred to as nominal interest. They are usually paid annually on fixed interest dates. If an investor buys a bond from the issuer between two interest dates, he receives the pro-rata interest from the issuer for the remaining term (accrued interest). If a bond is issued, the nominal interest rate depends on the prevailing market interest rate. In contrast to the nominal interest rate, the so-called market interest rate is constantly being formed and depends on macroeconomic factors. Expectations regarding inflation and the economy are important factors for the development of the market interest rate.

• Inflation
  If real purchasing power falls as a result of price increases, this usually leads to market interest rate increases, as the central bank is expected to raise interest rates. Rising market interest rates lead to falling bond prices.
• The economy
  Wages and salaries normally rise as the economy picks up. If wage increases are passed on to prices, this leads to inflation and thus to falling bond prices.
• Price development
  A bond is traded on the stock exchange until its maturity. Its price changes continuously and depends on supply and demand. The decisive factor for the price development is the ratio of the nominal interest rate to the respective market interest rate. If the market interest rate rises, the price of a bond falls. The yield approaches the market interest rate. Conversely, falling market interest rates lead to rising bond prices. Investors can use this situation to realize price gains when market interest rates fall. However, investors can only realise price gains if they sell the bond and do not wait until the end of the term.
• Psychological factors
  In the past, it was repeatedly observed that in times of economic crisis investors tend to transfer their investments to "safe havens". A "safe haven" is a bond issued by a country that can service outstanding bond claims at any time. The higher demand has a positive effect on bond prices.
• Tax aspects
  Investors should also note that when investing in bonds, interest and capital gains are taxed. Interest on capital assets and realized capital gains through sale are subject to a flat rate of 25 percent discount tax plus solidarity surcharge and, if applicable, church tax. This is paid to the tax office as withholding tax at the time of the inflow of income. At the same time, however, losses incurred can also be claimed for tax purposes, up to a maximum of the total amount of profits accrued and taxable in the relevant year.

Methods for the valuation of bonds

The valuation of a bond depends on the creditworthiness of the issuer. Creditworthiness is the quality of the issuer of the bond as the debtor. If the issuer meets its obligations to pay the nominal interest and is very likely to repay the nominal value of the bond, its credit rating is high. The creditworthiness of bond issuers is often assessed by rating agencies. The best-known are Moody's and Standard & Poors, although there are now also a number of smaller agencies, particularly for smaller issues. 

The valuation is important for the investment strategy of the investors. This, in turn, depends on the investor's risk appetite. Investors looking for a high level of security in their investment will, for example, acquire bonds with a first-class credit rating. Those who expect falling market interest rates are more likely to opt for long-term zero-coupon bonds.

Equities versus bonds

Shareholders have an interest in a company. They benefit from the company's earnings, which are, however, by no means certain. Bond holders, on the other hand, take on a creditor position that securitises money claims that are firmly guaranteed to them. Long-term investments have shown that equity investments generate a higher return than bond investments.

It makes sense to distribute your assets not only among several companies, but also among different forms of investment (e.g. shares and bonds). The advantage is that losses on equities can be offset by price gains on bonds. How the split between equities and bonds might look depends largely on the investor's individual preferences. Young investors will prefer to buy stocks because they want to benefit from higher long-term returns. Short-term fluctuations are less relevant because of the long investment horizon. Investors who value regular returns are more likely to choose bonds.

June 2019, © Deutsche Börse AG