Understanding Interest Rates and Yield

Interest rate is the income from bank and building society deposits, and takes different forms. It is essential that the investor develops an awareness of the types there are and how they differ from each other. As will be soon revealed, lack of such knowledge can lead to flawed decision making, with resultant investment losses.

The interest rate paid by banks and building societies can be fixed or variable, and depends on the economy’s basic rate. Between the extremes of fixed and variable interest rates is the roll-over’ type. An example, is a six-month roll-over interest rate, in which the rate remains fixed for six months and then changes to match the current interest rate in the market.

Interest rates are normally paid semi-annually or annually. Compounding of interest rates comes into play when interest has to be paid more than once a year. The effective interest rate, which is also called the annual percentage rate (APR) is in this case greater than the stated annual rate. For example, if 100 is invested at an annual rate of 6%, the money accumulated at the end of the year will be 106. If the interest is paid semi-annually, the APR is calculated as follows: the interest rate for both the first and second’ six months will be half of 6% which is 3%. The money accumulated at the end of the year will as such be given by 100 times 1.03 times 1.03, giving 106.09. There is an increase of 6.09 which is equivalent to 6.09% return on the 100 invested. Note that the APR is greater than the annual interest rate of 6%.

Ability to distinguish between nominal and real interest rate is of utmost importance to the investor, if unnecessary losses have to be eluded. Nominal or market interest rate, is the conventionally stated interest rate, and does not make allowance for inflation. Inflation robs both the principal invested and the return of purchasing power, and has to be considered when making investment decisions. The real’ interest rate allows for inflation. There is a relationship between real’, nominal’ and inflation’ rates which will be a useful tool to the investor. Real interest rate is obtained by subtracting 1 from (nominal interest + 1) divided by (inflation rate + 1). Thus if 100 is invested at a nominal’ rate of 3% and inflation rate is 3%, then the investor doesn’t have to be celebrating, since the real’ rate of return will be zero: [(1.03)/(1.03)] minus 1, which is zero. It is a good idea to also consider the effect of taxation on the real’ interest rate.

Finally let’s consider what is known as the redemption yield. Investment in bank and building society deposits provides only interest or interest yield as return, whereas an investment in a bond provides a capital gain or loss in addition to the promised coupon (fixed return). There is capital gain or loss because bonds are traded on the stock market and can lose or gain value due to market fluctuations. If a bond is purchased for 97 to be redeemed at 100. Let’s say there is a coupon of 4 to be paid semi-annually. Thus at the end of the year there will be a total coupon of 8 paid on 97 invested, which amounts to 8.25% p.a. [(8/97) x 100)] interest yield. If the bond is redeemed at 100, the gain in value of 3 amounts to 3.09% p.a. [(3/97) x 100] capital gain. The total return or redemption yield is the sum of the interest yield and the capital gain which is 8.25% plus 3.09%, giving 11.34 % p.a.

The underlying purpose of any investment is to make returns to compensate the investor for the risk taken. There will always be a lot of options to choose from, and a thorough understanding of the varieties of interest rates being dealt with, can lead to a well-informed investment decision. This will go a long way to foster the maximization of real’ expected returns, before and after tax.