TIR: The key metric to evaluate the actual profitability of your fixed income investments

What is the Internal Rate of Return (TIR)?

The Internal Rate of Return, commonly called IRR, is a fundamental percentage indicator in investment analysis that allows for an objective comparison of different capital allocation options. In the context of fixed income, the IRR reveals the effective return we will obtain from a bond, considering not only periodic income but also price variations relative to the nominal value.

Contrary to what many investors believe, the actual profitability of a bond is not solely reduced to its coupon. The IRR captures two sources of return: first, the interest payments (coupons) distributed periodically; second, the gain or loss generated by the difference between the purchase price and the nominal value at maturity.

Components that define a bond’s performance

Any ordinary fixed income security (those with a defined maturity and periodic coupons) operates with a specific mechanism: we pay an initial price, receive interest during its term, and at maturity recover the nominal plus the last coupon.

During the bond’s lifetime, its price fluctuates constantly for multiple reasons: changes in market interest rates, alterations in the issuer’s credit rating, and other macroeconomic factors. This price movement creates three possible purchase scenarios:

Purchase at par: The price paid exactly matches the nominal value. If the nominal is €1,000, we pay €1,000.

Purchase above par: We acquire the security at a price above the nominal. For example, paying €1,086 for a bond with a €1,000 nominal. This situation implies a guaranteed loss at maturity, as we will only receive the €1,000 nominal.

Purchase below par: We buy below the nominal. Suppose we pay €975 for a €1,000 nominal bond. Here, we realize a capital gain at maturity.

The IRR precisely synthesizes this behavior: it captures the return from the coupons plus the gain or loss derived from the difference between the purchase price and the redemption value.

Why IRR is your ally in bond selection

In investment practice, relying solely on the coupon yield can lead to incorrect decisions. Consider two real scenarios:

Bond A: Offers an 8% coupon but its IRR turns out to be 3.67%.

Bond B: Offers a 5% coupon but its IRR reaches 4.22%.

If we only considered the coupon, we would choose Bond A. However, analysis through IRR shows that Bond B provides a higher effective return. Why does this happen? Usually because Bond A was purchased at a significantly higher price than its par, which penalizes the final profitability when only the nominal is returned.

The IRR allows us to detect truly attractive investment opportunities and avoid bonds that, despite high coupons, hide inherent capital losses.

Differentiation between IRR, TIN, APR, and technical interest

It is essential not to confuse IRR with other interest rates present in the financial market, as each measures different aspects:

Nominal Interest Rate (TIN): Represents the pure and simple percentage agreed upon between parties, without including additional costs. It is the most basic and direct rate.

Annual Equivalent Rate (TAE): Incorporates supplementary expenses not evident in the initial offer. In the case of a mortgage, the TIN might be 2%, but the TAE 3.26% because it includes opening fees, insurance, and other costs. The Bank of Spain actively promotes the use of TAE as a comparison tool between financing options.

Technical Interest: Frequently used in the insurance sector, this indicator integrates additional costs specific to insurance products, such as life insurance premiums included in the contract.

IRR, on the other hand, provides a comprehensive view of profitability considering the full cash flow of the bond from purchase to maturity.

The IRR calculation formula

To calculate IRR, we need: the current price of the bond (P), the amount of the periodic coupon ©, the number of periods until maturity (n), and the nominal value (N). IRR is the rate that discounts all future flows to the current paid price.

Although the mathematical formulation is complex, specialized digital tools exist that perform these calculations automatically. The important thing is to understand the underlying logic.

Practical case 1 - Purchase below par:

Imagine a bond trading at €94.5, with an annual coupon of 6% and maturity in 4 years. Applying the corresponding formula, we obtain an IRR of 7.62%. Notice how the IRR exceeds the coupon because we bought below par, generating a capital gain.

Practical case 2 - Purchase above par:

The same bond, but now trading at €107.5. In this scenario, the IRR drops to 3.93%. The premium paid erodes the 6% coupon return, ultimately diluting it to an effective 3.93%.

Variables that influence IRR

Understanding these factors, you can roughly anticipate the range in which a bond’s return will move without performing complex calculations:

Coupon size: A higher coupon proportionally increases IRR; a lower coupon reduces it. This relationship is direct.

Purchase price: Buying below par increases IRR. Buying above par decreases it. This influence is decisive in the final profitability.

Special features of the instrument: Convertible bonds vary their IRR according to the evolution of the underlying stock; inflation-linked bonds (FRN) adjust according to inflation fluctuations. These adjustments modify expected cash flows and, therefore, IRR.

Final recommendations for investors

Although IRR is an essential indicator for identifying bonds with genuine profitability, it should not be your sole decision criterion. The credit quality of the issuer is equally critical.

During the Greek crisis of 2012-2015, Greek sovereign bonds traded with IRRs exceeding 19% annually, a clearly abnormal level reflecting imminent default risk. Only the intervention of the Eurozone prevented Greece from defaulting on its obligations. This example illustrates how an extraordinarily high IRR can signal not an opportunity, but a latent danger.

Use IRR as a profitability compass, but always analyze the issuer’s creditworthiness and macroeconomic context in parallel. An attractive IRR is worthless if the bond is not redeemable at maturity.