How IRR helps you make better choices in fixed income investments

If you’ve ever wondered why two bonds with different coupons don’t always mean different returns, then you need to understand what the IRR is. The Internal Rate of Return has become an essential tool for anyone looking to invest smartly, especially in the world of debt securities and bonds.

The IRR explains what the coupon doesn’t say

Here’s where it gets interesting: the coupon that a bond promises isn’t the only thing that determines how much you’ll earn. Imagine comparing two bonds: one offers an 8% annual coupon, but the other promises only 5%. If you choose based solely on this, you’d be making a serious mistake. The IRR is precisely what helps you avoid that mistake.

The Internal Rate of Return measures your actual profitability by considering two factors simultaneously:

First, periodic payments: The coupons you receive throughout the bond’s life (which can be annual, semiannual, or quarterly). These are your predictable cash flows.

Second, the gain or loss due to price: When you buy a bond in the secondary market, it may be trading below (at a discount), at (par), or above (at a premium) its nominal value. If you paid €105 for a bond with a €100 nominal, at maturity you’ll only receive €100. That €5 difference is a loss that the IRR already accounts for.

Clear differences between IRR, TIN, and APR

It’s crucial not to confuse these rates because each measures different things:

TIN (Nominal Interest Rate): Simply the agreed percentage. If you’re offered a 3% TIN, that’s exactly what it is: 3% without additional costs.

APR (Annual Percentage Rate): Includes commissions, insurance, and other costs not shown in the TIN. For example, a mortgage might have a 2% TIN but a 3.26% APR because it includes opening fees and mandatory insurances.

IRR (Internal Rate of Return): In fixed income, it’s your actual profitability considering the coupons you’ll receive plus the gain or loss due to the difference between what you paid and what you’ll get back at maturity.

How a bond really works

To understand why the IRR is so important, you need to know what happens throughout a bond’s life.

When you buy a regular bond, the issuer commits to:

• Returning the nominal at maturity
• Paying periodic coupons until then

Suppose a five-year bond: each period you receive your coupon, and at maturity, you get the last coupon plus the full nominal (€100 in this case).

But here’s the twist: the bond’s price fluctuates constantly in the secondary market. It doesn’t stay fixed during those five years. It moves according to changes in interest rates, the issuer’s credit rating, and other factors. This means that the entry point makes a huge difference.

If you buy below par (for example, at €94.5): You will profit from reverting toward the nominal. Besides the coupons, you’ll receive €5.5 more at maturity.

If you buy above par (for example, at €107.5): You’ll lose money on the reversion. Although you receive all your coupons, at the end, you’ll only get €100, which means a guaranteed loss of €7.5.

Practical examples to see the IRR in action

Let’s take a bond trading at €94.5, with a 6% annual coupon and 4 years to maturity.

Applying the discounted cash flow formula, the resulting IRR is 7.62%. Notice that it’s higher than the 6% coupon, thanks to the favorable purchase price below par.

Now, the same bond trading at €107.5:

The IRR drops to 3.93%. Although the coupon is identical (6%), the reality is that this overprice penalizes you, diluting your effective return.

This contrast shows why many investors make the mistake of only looking at the coupon: they might be choosing the less profitable option.

What factors truly move the IRR

Understanding what influences the IRR allows you to anticipate movements without complex calculations:

The coupon: Higher coupons = higher IRR. It’s the most direct relationship.

The purchase price: Buying below par boosts the IRR. Buying above par significantly reduces it.

Special features of the bond: A convertible bond also depends on how the underlying stock evolves. A FRN (floating rate bond) varies with market interest rates.

The trap: high IRR doesn’t always mean a good deal

Here’s the most important warning: the IRR is an excellent indicator, but it’s not the only variable you should consider.

During the Grexit crisis (2010-2015), the Greek 10-year bond traded with an IRR above 19%. It seemed incredibly profitable. But the reality was that the default risk was extremely high. Only the intervention of the Eurozone prevented Greece from defaulting, which would have meant total losses for holders.

The lesson: always verify the credit quality of the issuer before being seduced by an attractive IRR.

Why you need to know how to calculate the IRR

The IRR isn’t a trivial calculation like other financial ratios. It requires solving complex discount equations. Fortunately, there are online calculators that do the heavy lifting for you.

The important thing is that you understand what the result means: it’s your real annualized return, considering everything you’ll receive (coupons) minus what you paid today.

Smarter decisions with the IRR

When you have to choose between multiple bonds, the IRR gives you an objective criterion. Instead of being swayed by the coupon, you can compare the true profitability of each option.

Remember: the higher the IRR (while maintaining similar credit risk), the better your investment. But never ignore the issuer’s circumstances. An extraordinarily high IRR always hides something: either the market doubts that the money will be returned, or there’s a genuine opportunity that most haven’t yet seen.