What is a Bond Yield?
A bond yield is the return an investor realizes on a bond investment. Simply put, a bond yield represents the return on the capital invested by an investor. Bond yields and bond prices share an inverse relationship but can be understood through various methods, including the coupon yield, current yield, and yield to maturity (YTM) among others.
Key Takeaways
- Bond yield represents the return from an investment in a bond.
- Bonds can be purchased at a premium (above face value) or at a discount (below face value).
- The current yield is calculated as the bond’s coupon rate divided by its market price.
- Price and yield are inversely related: as bond prices rise, yields fall and vice versa.
Formula and Calculation of a Bond Yield
The simplest way to calculate a bond yield is to divide its coupon payment by the bond’s face value, known as the coupon rate.
Coupon Rate = Annual Coupon Payment / Bond Face Value
If a bond has a face value of $1,000 and provides $100 per year in interest (coupon) payments, its coupon rate is 10% or $100 ÷ $1,000.
Understanding Bond Yields
Bonds function as a loan to bond issuers and are generally considered safe investments. They offer investors a reliable income stream, paying interest during the bond’s life and returning the face value at maturity.
Investors can buy bonds at a premium or a discount, affecting the yield they earn. Bonds are rated for their risk by recognized agencies, from high-quality ‘AAA’ bonds to risky ‘D’ (junk) bonds.
Types of Bond Yields
- Coupon Yield: The fixed annual interest rate established when the bond is issued.
- Current Yield: This fluctuates with the bond’s price and its coupon payments.
Bond Yield vs. Bond Price
Price and yield are inversely related: as the price of a bond rises, its yield declines. For example, a bond with a $1,000 face value and a 10% annual coupon rate will earn $100 in interest annually. If market interest rates rise to 12%, the bond’s price will drop to match the market yield.
Conversely, if interest rates fall, the bond’s price increases because its coupon payments become more attractive. Although the bond’s coupon rate remains the same, the yield can be recalculated based on the new price.
Current Yield = Annual Coupon Payment / Bond Price
Additional Bond Yield Calculations
Yield to Maturity (YTM)
YTM equates the present value of all future cash flows from the bond to its current price. Solving for YTM involves the following formula:
Price = ∑ (Cash Flows_t / (1 + YTM)^t)
Bond Equivalent Yield (BEY)
The BEY adjusts for the bond’s coupon paid in two semi-annual payments. For bonds making semi-annual coupon payments, the BEY can be approximated by multiplying the semi-annual YTM by two.
Effective Annual Yield (EAY)
The EAY considers the time value of money, particularly for bonds with semi-annual coupon payments:
EAY = (1 + YTM / 2)^2 - 1
Bond Yield Calculation Issues
Calculations can be complicated by factors like fractional periods to maturity and accrued interest. To address this, terms like clean price and dirty price are used.
What Does a Bond’s Yield Tell Investors?
A bond’s yield reflects its return, either as a coupon yield or through more complex calculations like YTM. Higher yields point to larger interest payments but may indicate higher risk.
Are High-Yield Bonds Better Investments Than Low-Yield Bonds?
The suitability of high-yield or low-yield bonds varies based on investor goals, risk tolerance, and circumstances. Low-yield bonds may be ideal for those seeking low-risk investments, while high-yield bonds may attract those willing to embrace higher risks for better returns.
How Do Investors Utilize Bond Yields?
Investors use bond yields for sophisticated analyses, such as examining the yield curve and yield spreads to understand economic conditions and market trends.
The Conclusion
A bond yield signifies the return investors receive, calculated through simple coupon yields or intricate methods like YTM. It also indicates the bond’s credit quality, often reflecting the associated risk for the investor.
Related Terms: return, bond prices, coupon payment.
References
- U.S. Securities and Exchange Commission. “Bonds”.
- Forbes. “What Are Bond Rating Agencies?”
- U.S. Securities and Exchange Commission. “Investor Bulletin: Fixed Income Investments - When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall”.
- Forbes. “What Are Bond Rating Agencies?”
