For the income-oriented investor, or the investor comparing bonds to other forms of investment, it is important to be able to calculate the break-even point on bonds. This is the amount of time it takes for the stream of expected cash interest payments to equal the investment in the bond -- disregarding the return of principal or price appreciation, since price appreciation is unpredictable. The higher the interest rate, or the lower the price of the bond, the shorter the amount of time it takes for the bond to break even.
1. Determine the bond's coupon rate. This is the annual cash dividend payment the bond makes, expressed as a percentage of the bond's par value, or issuing price. This is normally $1,000, although some bonds, such as U.S. savings bonds, are available in smaller denominations.
2. Determine the annual interest payments from the coupon rate. A bond with a coupon rate of 6 percent will pay an annual dividend of $60, generally payable in two $30 interest payments, six months apart. Normally, the principal of the bond is paid back to the investor in a lump sum at a future date. However, some bonds, called zero coupons, do not pay interest payments. Instead, investors buy them at a discount and receive the full par value upon maturity. The break-even point calculation does not apply to them.
3. Divide the bond's purchase price by the annual interest payment. This is the number of years it will take for you to recover the cost of purchasing the bond, disregarding risk and inflation concerns. Do not use the par value of the bond, since many bonds are bought and sold at a price different from the par value. Note that the coupon rate of the bond and the percentage yield actually received can be very different. If you buy a bond for less than par value, you will experience a higher yield than the coupon rate. If you buy the bond at a premium to par value (usually because market interest rates have fallen), your yield will be lower than the coupon rate.
- This method of determining the break-even point for a bond is very simplified and does not take the returns on reinvested interest payments into account. For a more complex calculation, including a calculation of the point at which your return on investment is not affected by interest rate changes, you need to calculate a bond's duration. This calculation can be useful if you need to plan for a cash expenditure at a specific point in time and you do not want to be exposed to the risk that interest rates could change.
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