What is the Internal Rate of Return (IRR)?
According to Expansion, “The IRR of a financial debt asset is that one rate of discount or discount that equals the price of a bond with the flow of payments generated by the bond. In the case of debt assets, it is an indicator that reports on the average annual return on the maturity of a bond or obligation. It is useful when comparing bonds with various characteristics, coupons, and maturities. “
What is the Coupon, and How Does it Differ from the IRR (Yield)?
The coupon is the interest the bondholder will receive periodically for lending money to the issuing company/state. It is a fixed percentage established contractually, expressed in the bond’s prospectus.
The bonds become issued with a nominal value of $100 (or any of its multiples). This is when the coupon matches the return. Once they start trading on the market, their prices fluctuate according to supply and demand. In these cases, it is where the IRR can get away from the coupon. Each investor will buy the flow of funds (coupons + capital amortizations) at a specific value given by the current bond price. This price will determine the performance of each investor.
What is the Relationship Between the IRR and the Price of the Bond?
The price of a bond is based on its performance and has an inverse relationship. If the bond price drops, we buy it cheaper, so we have more profitability, and the IRR will increase. In other words, the investor is willing to pay less for the same flow of funds. If, on the contrary, the bond price goes up, we will buy it more expensive so that we will obtain less profitability, and the IRR will go down. In other words, the investor is willing to pay more for the same cash flow and coupon.
Issues to consider
The IRR calculated at the time of investing in the return that we will obtain at the end of the term and includes three elements:
- Coupons receivable throughout the life of the voucher
- Collection of the principal (capital amortizations)
- Reinvestment of coupons
What conclusions can we obtain?
For each sheet with a nominal value of $100, we will receive $8,375 annually in interest to be paid semi-annually.
- The bond is quoted on par. The purchase price is $117 (greater than $100).
- Consequently, the 8.375% coupon is higher than the 6.71% yield.
- The company will only obtain a yield of 6.71% if we keep the bond until maturity and reinvest the coupons to this same IRR. If we do it at a lower rate, we will obtain a lower yield; if it is at a higher rate, the product will increase.
With a duration of 10.04, the investment is expected to recover in about ten years.
American Market
The actions ended the session on Friday with a massive rally that helped push them to end the week with solid gains. The barrel price presented a recovery, and the shares responded accordingly. The US consumer sector is currently the leading economy. The supply of properties is limited, which helps maintain and even increase prices, but this situation can be reversed if wages do not improve.
The Bank of Japan also contributed to Friday’s rally after unexpectedly adopting a hostile interest rate policy for the first time. We should remain skeptical of the real benefits of this policy, given that Europe failed, although it is a sign that central banks are willing to act on the matter.
The S&P 500 Index (SPX) rose 1.7% in the week, while the Dow Jones Industrial Average ($ DJI) increased the indexes by 2.3%. The Nasdaq (QQQ) had a minimum rise of 0.03%, while the small caps (RUT, IWM) rose 1.5%. The S&P 500 Index (SPX) is outside correction territory, but markets are expected to remain volatile.
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