Returns and Interest Rates:
WHAT TO KNOW TO UNDERSTAND THE EARNINGS OF YOUR DEBT INVESMENT

Each day, the number of youth investors in Indonesia keeps skyrocketing. Statistics of the Indonesia Stock Exchange revealed that over a year culminating in February 2021, there had been a rise of the total of investors within the age range of 18-25 by just more than 50% (Utami, 2021). Many investor newcomers start by buying relatively less risky marketable securities – for one reason, this is a sagacious decision to make while growing a cumulative understanding of the nature of financial markets. Thus, it is not unusual to see novice investors transacting in a range of fixed income (or debt or bond) securities, which are generally notorious for rendering a lower level of risks, most notably relative to those in the stock markets.

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The escalating enthusiasm in opening new channels of passive income goes along with the surging scrutiny in the fundamentals of investing. Of paramount importance is an understanding of assessing the amount of gain one should expect when keeping a particular financial instrument – a critical ex-ante measure before considering whether the risk of purchasing the individual security reasonably well corresponds with the expected profit they will obtain. Apropos of debt instruments, some hocus pocus most frequently appears when talking about cash flows from holding them are 'interest rates' and 'rates of return'. At the surface, the two terms seem interchangeable. However, are they really identical? This article explains the two often confusing rates and how they can be applied when appraising how well a bond performs.

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Let's start with rates of return! What does it mean? A return is the profit of investment – that is, the reward we acquire from investing (Smart & Zutter, 2019). Returns indicate how well a person does by holding a bond or any other security over a particular period, and the rate of return serves as a quantified measure of such a quality (Mishkin & Eakins, 2018). It is worth mentioning that not every investment guarantees a return. Whilst you are most likely assured of gaining a return from saving deposits in a state-insured bank, you might be much less sure about such a prospect if you are to lend some money to your friend (Smart & Zutter, 2019).

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When you invest directly through brokers (in contrast to using the service of investment companies like mutual or pension funds), your return will generally be composed of two elements: income and capital gains. We can define income as the amount of money we receive from the asset's issuer as a financial asset holder. According to the types of securities, income can be realized in two forms: dividends for shares and interests for bonds. This is where an interest rate relates to the rate of return. Interest is the cost of borrowing or the price paid for funds rental (Mishkin & Eakins, 2018). An interest rate expresses such a cost as a percentage per year, although, in reality, systems of an interest payment can vary greatly for different kinds of bonds.

Among the most pervasively used forms of interest rates is the yield to maturity. A yield to maturity is the interest rate that equates the present value of cash flows from a debt instrument with its value today. For instance, a simple loan bought today for IDR 1,000,000 and is due exactly next year with a payment of IDR 1,100,000 has a yield to maturity of 10% (100% × [1,100,000 – 1,000,000] / 1,000,000). More sophisticated calculations of yield to maturity apply for other types of fixed income securities, but the general rule stated in its definition always stands.

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Another critical component of a return is capital gain. To understand this concept, you should note first that throughout its period to maturity, a bond can be sold to other investors. As for other goods and services, the market system affects the price of a debt instrument for a particular point in time. For instance, perhaps, after two years of holding an IDR 1,000,000 coupon bond with a 10% yearly interest rate, you know that the bond's price increases and sell it for IDR 1,300,000. Over the transaction, you will retrieve a capital gain of IDR 300,000 (1,300,000 – 1,000,000). However, there are also times when a bond's price plummets and at those times, you can only sell yours at a lower price than when you bought it – when this happens, you instead receive a capital loss.

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Notice that in the last case, you will also have received some portion of interest for holding the bond before you sell it (valued IDR 200,000, i.e., 10% × 1,000,000 for each of the two years). The sum of all the interests you have obtained and the capital gains acquired through sales equals the return of your investment – in this case, 300,000 + 200,000 = IDR 500,000. Accordingly, the rate of returns expresses the percentage of your return to the price of the bond at the time you bought it. For your coupon bond, this should be 500,000 / 1,000,000 = 50%.

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Thus, it is clear now that interest rates and rates of return are by no means identical. An interest of a bond is, in fact, a part of the bond's return before considering the effect of the market on its price at one point toward maturity. Although different systems of interest payment may apply for other kinds of fixed income instruments that the coupon bond discussed above, the general rule of return calculation still holds. With this understanding of the interest rate and the rate of return, now you can assess how good a bond performs when you start investing.