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Debt-based investments can offer stable and predictable income streams. By investing in a company or government entity’s debt, you’re lending them excess cash you have on hand now in return for future payments. Government treasury bills, corporate bonds, and commercial paper are all common examples of debt-based investments.
Unlike equity investments (e.g. stocks), debt investments typically tell you the exact income they pay out – this means you know exactly how much money you will receive each month, quarter, or even 30-year period, depending on the debt instrument. That makes them great for financial planning.
But what makes one debt investment better than another? With nearly limitless options, how does one make a smart choice?
It’s not obvious. The key is to analyze a debt investment’s expected return and compare that to the return on alternative investments. You’ll need to look at metrics such as yield, return on investment, and internal rate of return. Below is a simple guide to deciphering all three.
The yields tells us the rate of return on our investment, usually on an annual basis. In other words, it’s what percentage we will earn on our debt investment either by holding it to maturity, or by selling it now on the secondary market.
Let’s take a bond with the following characteristics:
First, What is the above bond’s current yield?
The current yield is how much an investor will earn each year from the bond’s coupon payments divided by its current price on the secondary market. This is a measure of present cash flow, telling us how much revenue a bond generates relative to its current price.
In our example, to get the current yield we divide the current market price of $980 by the annual coupon payment, or $50. Thus, 980/50 gives you a current yield of 5.1%. Note that bond prices and yields have an inverse relationship, so as the bond price drops – as it did in our example – the yield will rise.
But is 5.1% even an attractive rate? Well, it depends. Is there a better alternative?
You can compare a bond’s yield with that of other debt instruments, a benchmark rate, and current market interest rates in order to assess just how attractive the yield actually is. But be warned: while higher yields might mean a better return on investment, they can also imply higher risk. An extremely high yield compared to market rates could mean the company or government entity is likely to default.
Another important measure of yield is Yield to Maturity (YTM). This is the total rate of return you would earn if you bought the bond at its current market price, held it until maturity, and immediately reinvested the proceeds after each payout.
YTM is a more complex measurement. In the above example, it would take into account how much you would earn if you immediately re-invested each $50 coupon payment at the same interest rate.
You can use websites like this one to calculate a bond’s YTM.
The Cash-on-Cash return is a relatively simple way to compare investments and decide which are profitable.
You calculate it by dividing the investment’s total profit by its cost (then multiply by 100 to make it a percentage).
The equation looks like this: Cash on Cash = Net income / cost of investment x 100
IRR is a more comprehensive measurement. Unlike Cash on Cash, it considers the time value of money, something especially important for longer term investments.
IRR tells us whether an investment is viable and the annual growth rate it is expected to achieve. It provides a threshold rate – below this rate it would be more profitable to invest in alternatives.
In more technical terms, the IRR is the rate at which the present value of future cash flows equals the initial investment. In other words, since money is worth more now than in the future, we want to see if the future earnings – when adjusted for time – exceed what you have to pay now to invest. If they don’t, it’s probably not a good investment.
IRR is a better metric for evaluating long-term projects, as cash flows far into the future are worth less than they are right now. Investors compare the IRR to a hurdle rate (the minimum rate they’re looking to earn), to decide whether the investment is attractive.
You can calculate the IRR with an online calculator at websites like this.
