Recently, someone asked me how they can really know how much they will earn with a bond. The answer lies in the IRR, although many people completely ignore it.

The Internal Rate of Return is nothing more than that: the actual profitability you get from a fixed-income investment. It sounds simple, but here’s where it gets interesting. When you buy a bond, your profit doesn’t come only from the coupon payments. It also depends on the price you paid for it.

Think of it this way: if a bond promises you 6% annual coupons but you buy it at 94.5 euros when its face value is 100, you’re earning something extra when it matures. Conversely, if you buy it at 107.5 euros, that premium penalizes you in the end. That’s why the IRR formula is so important: it shows you the full return, not just the coupon.

This is where many get lost. The coupon is what you see at first glance. The nominal interest rate (TIN) is simply that percentage without accounting for expenses. The APR (TAE) already includes additional costs (typical in mortgages). But the IRR on bonds is different: it accounts for both the coupons and the gain or loss from the purchase price.

Let me give you a real example. You have two bonds. The first pays an 8% coupon but its IRR is 3.67%. The second pays 5% but its IRR is 4.22%. If you only look at the coupon, you choose the first. But if you correctly calculate the IRR formula, the second is better. Why? Probably because the first is trading very expensively in the market.

Calculating this manually is tedious. The formula involves solving an equation where you find the rate that equates the current price with all future cash flows (coupons and principal repayment). Basically, you need to find the discount rate that makes the present value of all those payments equal to what you paid today.

Let’s take a bond that costs 94.5 euros, pays 6% annually, and matures in 4 years. Using the correct formula, its IRR comes out to 7.62%. That’s higher than the 6% coupon because you bought it cheaply. Now, the same bond at 107.5 euros: its IRR drops to 3.93%. See how the price changes everything.

Three things influence the IRR: first, the coupon (higher = higher IRR). Second, the purchase price (buying below par increases IRR, buying above par decreases it). Third, there are special bonds like convertibles or inflation-linked bonds that have more complex behaviors.

The key lesson: use the IRR to compare bonds, but don’t rely on it blindly. During the Greek crisis, Greek bonds reached a 19% IRR. Sounds incredible, right? But it was because the default risk was huge. In the end, they needed European rescue to avoid bankruptcy. So yes, calculate the IRR formula to find good bonds, but always check the issuer’s credit health. High returns without security are just an illusion.