There’s a sudden rush of debenture public issues in the market and you can benefit from investing in such debentures in two ways. If you choose to hold the debenture till maturity, you will receive a periodic interest (coupon) or cumulative interest. On the other hand, you could choose to trade the debenture on an exchange after it gets listed and for that you need to look at the yield that such debentures are trading at.
The yield on a listed security is different from the effective yield of a security which you hold till maturity. Here is how. Keep in mind that any discussion of yield considers the annual yield.
Coupon and effective yield
Coupon refers to the rate of interest the company offers to pay the debenture holder at a predetermined frequency. For example, if a non-convertible debenture (NCD) is offering 12.5%, it means that the coupon or annual interest is 12.5% of the invested amount. This can be paid out monthly, quarterly, annually or cumulatively at the end of the tenor of the bond or at any other frequency the company may decide.
If the interest is paid out annually, then the effective yield on an annual basis is the same as the coupon rate. If the coupon amount is paid out at monthly intervals, that will increase the effective yield in the above example to, say, 13.25%. This happens because you get money every month and it is assumed that you will be able to reinvest that money at the rate of 12.5% per annum, thereafter. Similarly, if you invest Rs.1,000 in a bond that offers to double your money in six years and pay Rs.2,100 at the end of that period, then you don’t have a coupon rather you get accumulated interest at the end of the tenor and the effective yield of your earning is 13.16% per annum. This kind of representation of yield shows what you will earn by holding a bond.
Once a bond is listed on an exchange, it carries a market price, which is essentially determined by demand and supply. The market yield of the bond is linked to this price. This is also referred to as the current yield, which is calculated by dividing the coupon rate with the market price of the bond and multiplying with the face value. So if a bond with a face value of Rs.100 and 10.5% coupon is currently trading at Rs.103, then the current yield is 10.19%. Bond yield and prices have an inverse relationship—when prices rise, yields fall and vice-versa. This happens because at a higher market price, you get the same coupon. So in the example above, at a price of Rs.103 per bond, you get an interest of Rs.10.5 per annum, which you earlier got by paying Rs.100 per bond, so the current yield is lower at 10.19%.
So if you missed out on the opportunity to subscribe to a public issue of debentures that you wanted, look for a listed security. If you want to hold till maturity, it works well for you that the bond is trading at a discount—bond price is less than the face value and yield is higher than the coupon rate. Traders will evaluate other market conditions and may buy bonds both at a discount and premium.