What Is a Bond Yield?
Understanding bond yields can make investors more confident when adding bonds to their investment portfolios.
Bond Yields Explained
When an investor buys a bond, they are essentially lending money to the bond's issuer who in turn agrees to pay the investor interest over the lifetime of the bond and the principal upon maturity. Corporations, governments, and municipalities all issue bonds when they need to raise investment capital.
A bond yield is the return on capital invested in a bond, and there are several types of ways to measure it. But first, let's go over the components of a bond:
- Issue price: the price that a bond is sold for by the original issuer
- Par or face value: the amount that the bond will be worth at maturity, it is also the base amount on which the bond's interest is calculated
- Coupon rate: the bond's interest rate which is a percentage of the bond's face value; for example, if a bond has a coupon rate of 5% and a face value of $1,000, it will pay $50 in interest annually
- Coupon dates: the dates on which a bond issuer makes interest payments; most bonds pay interest semi-annually
- Maturity date: the date on which the issuer pays the bondholder the face value of the bond.
It's important to understand that a bond's price and its face value are not always the same since, once a bond is issued, it's bought and sold on the open market. The yield will differ from the coupon rate if the price of a bond is above or below face value.
Types of Bond Yields
The various types of bond yields are:
1. Current Yield
Often, a bond is repurchased before its maturity, either for a premium or discount to its face value. When this happens, current yield is different from coupon rate. The formula for calculating current yield is:
Current Yield = Annual Coupon Payment / Bond's Market Price
For example, a $1,000-face value bond having a coupon rate of 5% might be trading at $1,040, so its current yield would be: .05/1,040.00 = 4.8%The next day, that same bond might be trading at $1,020, so its coupon yield would be:.05/1,020.00 = 4.9%
It is only when a new bond is bought at par and held until its maturity that its coupon rate and its current yield will be the same.
2. Yield To Maturity (YTM)
Yield to maturity is an investor's expected return after keeping the bond until the maturity date, and it includes all the bond's coupon payments. Yield to maturity is expressed in annual percentage terms. While current yield measures the present value of the bond, yield to maturity measures the bond's value at maturity. The formula for calculating yield to maturity is:
Yield to Maturity = [C + (F - P)/n] / [(F + P)/2]
- C = the bond's coupon rate
- F = the bond's face value
- P = the bond's current market price
- n = the number of years until maturity.
3. Yield To Call (YTC)
Yield to call (callable or redeemable) bonds can be paid off by the bond issuer before the bond's maturity date. YTC takes into account the effect on the bond's yield should it be called before maturity, and calculations of YTC should use the first date on which the bond could be called. Investors are paid the call price, which is usually the face value of the bond, along with the accrued interest to date. The formula for calculating YTC is:
Yield to call = [C + (F - P)/n] / [(F + P)/2]
- C = the bond's coupon rate
- F = the bond's face value
- P = the bond's call price
- n = the number of years until the call date.
4. Bond Equivalent Yield (BEY)
Bond equivalent yield takes into account the fact that most bonds pay interest in two semi-annual payments, if the coupon payments were paid annually, the YTM would be equal to the BEY, however, semi-annual coupon payments cause a different YTM. The formula for calculating the BEY is:
BEY = YTM * 2
The BEY does not take into account the time value of money (TVM) when going from a semi-annual YTM to an annual YTM. It's a useful measure when comparing two bonds with different payout frequencies.
5. Effective Annual Yield (EAY)
Effective annual yield is a measurement that takes into account compounding. It assumes that interest payments are reinvested. For a semi-annual coupon payment, the formula for calculating EAY is:
Effective Annual Yield = ((1 + YTM /2)squared) - 1
6. Yield To Worst (YTW)
Yield to worst is the worst-case potential return of a bond, especially for a callable bond, and it is whichever is lower between YTM or YTC.
Yield to Worst = YTM or YTC (whichever is lower)
How To Calculate a Bond Price
In all bond yield calculations, if you know the bond yield but not the bond price, you can solve for the price using the yield equation. Fortunately, there are several online calculators that allow investors to determine the yield and the price of a bond including, Omni Calculator, Calculate Stuff, and Dqydj.
When Bond Yields Rise or Fall
A bond's price moves in the opposite direction to its yield because a bond's price reflects the cost of the income that the bond provides through its regular coupon payments. When interest rates fall, all types of existing bonds become more valuable because their coupon rates are higher than that of new bonds, and these existing bonds can be sold at a premium on the secondary market. If interest rates rise, investors can get a higher coupon rate on new bonds and existing bonds become less valuable. Their prices fall and they trade at a discount.
Let's look at a bond that has:
- A face value of $1,000
- A coupon rate of 5%
- A maturity date of 10 years
Every year, the bond pays $50 in interest. Now, suppose interest rates on new $1,000-bonds rise to 7.5%. If an investor wants to sell this bond before it matures, it would be competing with new bonds that pay $75 annually rather than $50. To attract buyers, the investor must lower the price to a point where the coupon payments plus the maturity value will be equal to the 7.5% yield.
If interest rates were to fall, say from 5% to 3%, the bond's price would rise because its coupon payment is more attractive.
Bond Yield Curves
Bond yields are typically graphed, with the y-axis displaying interest rates, and the x-axis displaying maturities. As would be expected, bonds having longer maturity dates have higher interest rates to compensate investors for the longer lockup period. Bond yield curves are influenced by macroeconomic conditions and the actions taken by the Federal Reserve.
The yield curve shown above is upward sloping as expected, with the yield rising as the maturity period gets longer. In the fictionalized chart, the rate on a 30-day bond is 2.55% while that of a 20-year bond is 4.8%. When a yield curve flattens, it means that investors are receiving around the same return from a short-term bond as they are from a long-term bond.
When the yield on short-term bonds is greater than the yield on long-term bonds, the slope of the yield curve is inverted. An inverted Treasury bond yield curve is one potential signal of a coming recession.
How Investors Use Bond Yields
Investors use bond yields to determine the expected returns of individual bonds. Bond traders analyze different categories of bonds, such as corporate or government bonds, that have the same or similar yields, and they look to a bond's yield curve for clues as to future market activity and interest rates.
Bottom Line
Understanding bond yields is a prerequisite for trading in bond markets. Also, bond yields can serve as harbingers of future movements in both bond and equity markets.
This article was written by
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