What Is a Bond Yield?

A bond yield refers to the return an investor gains from holding a bond. Simply put, it is the return on the money an investor puts into purchasing a bond. It’s crucial to note that bond yields differ from bond prices, with the two having an inverse relationship. When a bond is first issued, its yield corresponds to its coupon rate. Bond yields can be calculated in various ways, such as the coupon yield and current yield. More advanced calculations include yield to maturity (YTM) and other methods.

Key Takeaways

• Bond Yield: The return an investor earns from a bond.
• Purchase Price: Bonds can be bought at a premium (above face value) or a discount (below face value), which affects the yield.
• Current Yield: Calculated by dividing the bond’s coupon rate by its market price.
• Inverse Relationship: Bond prices and yields are inversely related; as one goes up, the other goes down.

Understanding Bond Yields

A bond is essentially a loan to the bond issuer, and bonds are considered relatively safe investments. This is because the value of bonds is generally more stable than stock prices. Bonds provide investors with a dependable stream of income, offering fixed interest payments (also known as coupon payments) over time.

Throughout the life of the bond, investors receive interest payments and, when the bond matures, the face value is returned to the bondholder. Depending on market conditions, investors can buy bonds at a premium or at a discount, which in turn affects the yield.

Bonds are rated for their credit quality by agencies authorized by the Securities and Exchange Commission (SEC). The ratings range from “AAA” (low-risk investment grade) to “D” (bonds in default, or junk bonds, which have the highest risk).

Bond Yield Concepts

• Coupon Yield: The coupon yield is the interest rate set when the bond is issued. It remains fixed for the bond’s entire duration.
• Current Yield: This yield changes based on the bond’s price and its coupon payments. If the bond’s price fluctuates, its yield will also adjust.

Formula and Calculation of Bond Yield

The most straightforward way to calculate bond yield is by dividing the coupon payment by the bond’s face value. This is called the coupon rate:

Here’s the formula:

Coupon Rate = (Annual Coupon Payment / Bond Face Value) × 100
    

For example, if a bond has a face value of $1,000 and the annual coupon payment is $100, the coupon rate would be:

Coupon Rate = (100 / 1000) × 100 = 10%
    

Bond Yield vs. Bond Price

Bond yields and prices move in opposite directions. When a bond’s price rises, its yield falls, and vice versa. For example, if an investor buys a bond with a face value of $1,000 that pays an annual coupon rate of 10%, they receive $100 annually. If interest rates rise to 12%, the bond’s price will drop since newer bonds pay higher interest.

If the market offers bonds with a 12% yield, the original bond will become less attractive with its 10% coupon. To make it competitive, the price of the original bond would have to decrease to match the higher interest rate.

Current Yield Calculation

The current yield can be calculated by dividing the bond’s annual coupon payment by its market price:

Current Yield = (Annual Coupon Payment / Bond Price) × 100
    

Additional Bond Yield Calculations

Yield to Maturity (YTM)

YTM is the rate of return that makes the present value of a bond’s future cash flows equal to its current price. The formula for YTM is:

Price = Σ (Cash Flows_t / (1 + YTM)^t)
    

Bond Equivalent Yield (BEY)

Bonds are often quoted using the bond equivalent yield, which adjusts for semi-annual coupon payments. If a bond pays $50 every six months, its semi-annual YTM might be 5.979%. The BEY annualizes this figure by multiplying it by two:

BEY = Semi-annual YTM × 2
    

Effective Annual Yield (EAY)

EAY accounts for the time value of money, providing a more precise annual yield than the BEY. It’s calculated as:

EAY = (1 + (YTM / 2))^2 - 1
    

Bond Yield Calculation Issues

Bond yield calculations can be complicated due to factors like fractional maturity periods and accrued interest. For instance, if a bond has 4 years and 8 months to maturity, the exponent in the yield formula can be converted to a decimal to adjust for partial years.

What Does a Bond’s Yield Tell Investors?

A bond’s yield indicates the return an investor can expect from the bond’s interest (coupon) payments. It can be calculated as a simple coupon yield or a more complex yield-to-maturity calculation. High yields usually mean higher interest payments, but they can also signal higher risk.

Are High-Yield Bonds Better Investments Than Low-Yield Bonds?

The answer depends on the investor’s objectives and risk tolerance. Low-yield bonds are often safer and may suit conservative investors or those who want to hedge their portfolios. High-yield bonds, on the other hand, offer higher returns but carry more risk.

How Do Investors Utilize Bond Yields?

Bond yields allow for more advanced investment strategies. By comparing yields of bonds with different maturities, investors can evaluate the yield curve, which represents the interest rates of bonds of equal credit quality but differing maturities.

The Bottom Line

Bond yield represents the return an investor earns on a bond. Simple yield calculations include the coupon rate and current yield, while more advanced calculations like yield to maturity offer a more complete picture. Additionally, bond ratings help investors gauge the credit risk associated with a bond investment.