TIR: The essential metric for evaluating fixed income investments

Why IRR is Your Ally in Decision Making

When faced with choosing between two different investments, you need an objective tool that goes beyond the superficial. The Internal Rate of Return (IRR) is precisely that: a percentage measure that allows you to compare investment options clearly and directly.

In the universe of bonds and debt securities, IRR reveals the actual return you will obtain, considering not only the coupons you receive but also the gains or losses derived from the purchase price of the asset. It’s the difference between seeing only the surface and understanding the true value of your investment.

What is IRR Really?

IRR represents the percentage return generated by an investment from its start until maturity. Unlike the nominal coupon that a bond appears to offer, IRR incorporates all the cash flows you will receive, adjusted for the current market price of the asset.

Your return as a fixed-income investor comes from two different sources:

Coupons: These are the periodic payments made by the issuer, usually annually, semi-annually, or quarterly. They can be fixed, variable, or floating (linked to indices like inflation). Some bonds, known as zero-coupon bonds, do not generate coupons at all.

Price difference: This is where the crucial point lies. A bond purchased at 94 euros will appreciate to 100 euros (its nominal value) at maturity, generating a capital gain. Conversely, if bought at 107 euros, you will suffer a loss of 7 euros upon receiving only the nominal 100.

The Mechanics of Bonds: Understanding Price and Par

A regular bond works like this: it issues a nominal value (say 100 euros), pays periodic coupons during its life, and at maturity, returns the full nominal.

What’s fascinating is that the bond’s price fluctuates constantly in the secondary market. This variation depends on factors such as changes in interest rates and the credit quality of the issuer. This is where the importance of smart buying emerges:

Buy at par: You acquire the bond exactly at its nominal value. No surprises.

Buy below par: You buy below the nominal. At maturity, you will gain capital that adds to the coupons. This situation typically results in a higher IRR.

Buy above par: You buy above the nominal. Although you receive the full coupons, you will suffer a capital loss when reverting to the nominal value. This significantly reduces your final IRR.

Differentiating Between Rates: IRR vs. TIN vs. TAE

It’s essential not to confuse these metrics, as each tells a different story about your profitability.

IRR is the actual return you will get from a specific bond, considering its current market price and all its future cash flows discounted.

TIN (Nominal Interest Rate) is simply the pure percentage you agreed upon. It’s the most naive of the three: it does not include additional costs. For example, a mortgage might have a TIN of 2%.

TAE (Annual Equivalent Rate) is the most honest representation of what you will actually pay, as it includes all hidden expenses: commissions, insurance, etc. The same mortgage with a TIN of 2% could have a TAE of 3.26%.

Technical Interest is mainly used in savings insurance, incorporating costs such as the underlying life insurance.

How to Calculate IRR: The Formula and Its Applications

The mathematical formula for IRR is complex for manual calculation, but its concept is clear: it’s the discount rate that equates the current price of the bond with the present value of all its future cash flows.

In practical terms, if you have:

• Purchase price (P)
• Periodic coupon ©
• Time to maturity (n)
• Nominal value (N)

You can apply the standard formula that equates: Current price = Discounted future cash flows by IRR.

Practical Example 1: A bond trades at 94.5 euros, offers a 6% annual coupon, and matures in 4 years.

Applying the formula, we get an IRR of 7.62%. This yield exceeds the 6% nominal because you bought the bond below par, capturing the additional capital gain.

Practical Example 2: The same bond, but now trading at 107.5 euros.

In this case, the IRR drops to 3.93%. The premium paid severely penalizes your return. Although you receive the 6% coupons, the capital loss at maturity reduces your actual return nearly in half.

Given the tediousness of manual calculation, online calculators are available that simplify the process by simply entering the bond parameters.

Key Factors That Modulate Your IRR

Several elements determine your final profitability level. Understanding them allows you to make approximate predictions without complex calculations.

Coupon: The higher the coupon, the higher the potential IRR. A bond paying 8% will generate higher returns than one paying 2%, all else equal.

Purchase price: This is the multiplier of your profitability. Buying below par increases your IRR; buying above par drastically reduces it.

Special features: Certain bonds have special clauses. Convertible bonds vary their IRR depending on the evolution of the underlying stock. Inflation-linked bonds adjust as this index fluctuates. Floating-rate bonds (FRN) adjust their coupons with reference rates.

How to Use IRR to Make Investment Decisions

IRR is your comparative compass. When evaluating two bonds, IRR indicates which one truly offers higher profitability, not the misleading nominal coupon.

Suppose you have bond A with an 8% coupon (but IRR of 3.67%) and bond B with a 5% coupon (but IRR of 4.22%). Relying solely on the coupon would lead you to choose A, but IRR reveals that B is the superior asset. The reason: A is trading well above par, undermining actual returns.

For larger investment projects, IRR also helps evaluate viability. If your cost of capital is 5%, any project with an IRR above that is viable; if below, discard it.

Credit Risk: The Greek Lesson

Here comes a critical warning: never forget to consider the creditworthiness of the issuer along with IRR.

During the Grexit crisis, 10-year Greek bonds reached an IRR of over 19%, which was an obvious anomaly. This extremely high yield reflected imminent default risk, not a genuine opportunity. Only the intervention of the Eurozone prevented total collapse. If you had invested solely based on that attractive IRR, you would have faced devastating losses.

Conclusion: IRR as Your Informed Ally

Use IRR as your main tool to compare fixed-income investments. Always choose the asset with the highest IRR, but always—always—verify that the issuer maintains solid credit health. Return and security must go hand in hand. Understanding how to calculate IRR and its practical application puts you in a position to make genuinely profitable decisions, protecting your capital from unpleasant surprises.