Comparison of Equity Returns with Bond Returns
This sub‑topic explains how returns from equities differ from returns earned on bonds, the ways each is measured, and why the distinction matters for a research analyst. Understanding the comparison helps you answer exam questions on risk‑adjusted performance and portfolio construction. The content links directly to the Fundamentals of Risk and Return chapter of NISM Series XV.
Learning Objectives
- 1Define the components of equity and bond returns.
- 2Calculate equity holding‑period return and CAGR.
- 3Calculate bond current yield and approximate YTM.
- 4Compare risk, liquidity and tax treatment of equities versus bonds.
Equity Returns vs. Bond Returns – Core Concepts
Equity returns arise from two sources – price appreciation (or depreciation) of the share and dividend income received during the holding period. In the Indian market, dividends may be paid in cash or scrip, and the total return must include both components.
Bond returns are generated through periodic coupon payments and any change in the bond’s market price. For a fixed‑coupon government or corporate bond, the coupon is a fixed percentage of the face value, while the price may move up or down depending on interest‑rate changes and credit risk.
For the NISM exam, you must be able to distinguish these sources, recognise the appropriate formula for each, and understand how the time horizon influences the measured return.
- Equity – price change + dividend.
- Bond – coupon + price change.
Candidates often forget to adjust equity returns for inflation when the question asks for real returns. Remember: real return = (1 + nominal) / (1 + inflation) – 1.
Calculating Equity Returns
The simplest measure is the Holding‑Period Return (HPR). It captures the total gain or loss over the exact period you own the equity, expressed as a percentage of the initial investment.
When the holding period spans multiple years, analysts often use the Compound Annual Growth Rate (CAGR) to annualise the return. CAGR smooths out volatility and is useful for comparing equities with bonds, which are usually quoted on an annual basis.
In exam scenarios, be careful to use the correct denominator. For HPR the denominator is the initial price (P0); for CAGR the denominator is the number of years (n). Ignoring dividends in HPR is a common mistake that leads to under‑stating equity performance.
Where:
P_{0}= Initial share price in rupeesP_{1}= Ending share price in rupeesD= Total dividend received per share in rupeesWorked Example
Given P0 = 1000, P1 = 1100, D = 50: Step 1: HPR = (1100 - 1000 + 50) / 1000 Step 2: HPR = 150 / 1000 Step 3: HPR = 0.15 or 15% Verification: (1100 - 1000 + 50) / 1000 = 0.15.
Where:
V_{i}= Initial value of the investment (including price and dividends) in rupeesV_{f}= Final value of the investment in rupeesn= Number of years the investment was heldWorked Example
Given Vi = 1000, Vf = 1500, n = 3: Step 1: Ratio = 1500 / 1000 = 1.5 Step 2: Exponent = 1 / 3 ≈ 0.3333 Step 3: CAGR = 1.5^{0.3333} - 1 ≈ 1.1447 - 1 = 0.1447 or 14.47% Verification: (1500/1000)^{1/3} - 1 = 0.1447.
Calculating Bond Returns
Bond returns are often expressed as a yield. The most basic yield is the Current Yield, which relates the annual coupon payment to the bond’s current market price.
For a more accurate measure that incorporates price appreciation or depreciation over the bond’s life, analysts use Yield to Maturity (YTM). The exact YTM requires solving a present‑value equation, but the NISM syllabus provides an acceptable approximation.
When comparing with equities, remember that bond yields are quoted on an annual basis, so you must annualise any equity return (using CAGR) before making a side‑by‑side comparison.
Where:
C= Annual coupon payment in rupeesP= Current market price of the bond in rupeesWorked Example
Given C = 80, P = 950: Step 1: Current Yield = 80 / 950 Step 2: Current Yield = 0.0842 or 8.42% Verification: 80 / 950 = 0.0842.
Where:
C= Annual coupon payment in rupeesF= Face (par) value of the bond in rupeesP= Current market price of the bond in rupeesn= Years to maturityWorked Example
Given C = 80, F = 1000, P = 950, n = 5: Step 1: (F - P)/n = (1000 - 950) / 5 = 10 Step 2: Numerator = 80 + 10 = 90 Step 3: Denominator = (1000 + 950) / 2 = 975 Step 4: Approx YTM = 90 / 975 = 0.0923 or 9.23% Verification: (80 + (1000-950)/5) / ((1000+950)/2) = 0.0923.
Side‑by‑Side Comparison
Key Differences Between Equity and Bond Returns
| Aspect | Equity | Bond |
|---|---|---|
| Return Components | Price change + dividends | Coupon + price change |
| Typical Annual Return (India) | 10‑15% (historical equity index) | 7‑9% (government & high‑grade corporate) |
| Risk Level | Higher market risk, volatility | Lower interest‑rate & credit risk |
| Liquidity | Highly liquid on NSE/BSE | Liquidity varies; government bonds highly liquid, corporate bonds less so |
| Tax Treatment | Dividends taxed at 10% (post‑2020), capital gains as per slab | Interest taxable as income, capital gains tax on price appreciation |
Historical Return Illustration
Average 5‑Year Returns (India, 2018‑2022)
When the question asks to compare equity and bond returns, first convert equity returns to an annualised figure (CAGR) before juxtaposing with bond yield or YTM.
Scenario
Rohit, a 35‑year‑old investor, can invest ₹1,00,000 either in an equity mutual fund that historically delivered a 13% CAGR or in a 5‑year corporate bond fund offering a YTM of 9.5%. He plans to hold the investment for exactly 5 years.
Solution
Step 1: Compute the expected equity value after 5 years using CAGR: Future Value = 1,00,000 × (1 + 0.13)^{5} ≈ 1,00,000 × 1.842 = ₹1,84,200. Step 2: Compute the bond’s future value using the YTM approximation: Approx final amount = 1,00,000 × (1 + 0.095)^{5} ≈ 1,00,000 × 1.570 = ₹1,57,000. Step 3: Compare: Equity fund yields about ₹27,200 more than the bond fund over the same horizon. Step 4: Consider risk: Equity is higher volatility, while bond offers capital protection. The exam may ask which option provides higher expected return – answer: equity fund.
Conclusion
The equity fund gives a higher expected return over 5 years, but the analyst must also discuss the higher risk exposure, which is crucial for a balanced recommendation.
Implications for Research Analysts
Research analysts must present return comparisons in a way that investors can easily interpret. This means annualising equity returns, stating the yield type for bonds, and disclosing any assumptions such as dividend reinvestment.
Analysts also adjust returns for risk using metrics like the Sharpe ratio or equity risk premium. While the NISM syllabus does not require the Sharpe formula here, knowing that higher returns must be justified by higher risk is essential for exam answers.
Finally, analysts should highlight tax implications because after‑tax returns can flip the ranking, especially when bonds are taxed at higher marginal rates than long‑term capital gains on equities.
Many candidates calculate equity returns using only price change, forgetting that dividends, when reinvested, significantly boost the total return. Always add dividends to the HPR or use CAGR on total wealth.
Risk‑Return Trade‑off Summary
Equities typically offer a higher risk premium because they are exposed to market risk, company‑specific risk, and earnings volatility. Bonds, especially government securities, provide lower but more predictable returns.
The risk‑adjusted return is what the exam often probes. For equities, beta measures systematic risk; for bonds, duration measures sensitivity to interest‑rate changes. While the syllabus does not require detailed calculations here, knowing the concepts helps you justify why an equity’s higher return compensates for its higher risk.
Remember: the appropriate comparison is "annualised return vs. annualised return" and must be contextualised with risk, liquidity, and tax considerations.
Cumulative Growth: Equity vs. Bond (5‑Year Horizon)
⭐Exam Takeaways
- Equity return = price change + dividend; bond return = coupon + price change.
- Holding‑Period Return (HPR) formula: (P1‑P0+D)/P0.
- CAGR annualises equity returns: ((Vf/Vi)^{1/n})‑1.
- Current Yield = Coupon/Price; Approximate YTM = (C + (F‑P)/n) / ((F+P)/2).
- Always compare returns on the same time basis – annualise equity returns before juxtaposing with bond yields.
Practice Questions
8 questions on Comparison of Equity Returns with Bond Returns
What are the two components that constitute equity returns?
Which formula correctly represents the Holding‑Period Return (HPR) for an equity?
An investor buys a share at ₹800, sells it at ₹880 after one year and receives a dividend of ₹40. What is the Holding‑Period Return?
An investment’s initial value is ₹2,000 and its final value after 4 years is ₹2,600. What is the Compound Annual Growth Rate (CAGR)?
A bond has an annual coupon of ₹90, face value ₹1,000, current price ₹970 and 6 years to maturity. Using the approximation formula, what is the Yield to Maturity (YTM)?
An equity fund has historically delivered a 12% CAGR, while a comparable bond offers a current yield of 8.5%. Which investment provides the higher annualised return?
Which statement correctly describes the tax treatment of equity dividends and bond interest in India?
An equity investment yields a nominal return of 15% while inflation is 4%. What is the real return?