What is Bond Yield?
Bond yield is the return an investor realizes on a bond. The bond yield can be defined in different ways. Setting the bond yield equal to its coupon rate is the simplest definition. The current yield is a function of the bond’s price and its coupon or interest payment, which will be more accurate than the coupon yield if the price of the bond is different than its face value. More complex calculations of a bond’s yield will account for the time value of money and compounding interest payments. These calculations include yield to maturity (YTM), bond equivalent yield (BEY) and effective annual yield (EAY). (Discover the difference between Bond Yield Rate vs. Coupon Rate). 1:56
Bond Yields: Current Yield And YTM
Overview of Bond Yield
When investors buy bonds, they essentially lend bond issuers money. In return, bond issuers agree to pay investors interest on bonds through the life of the bond and to repay the face value of bonds upon maturity. The simplest way to calculate a bond yield is to divide its coupon payment by the face value of the bond. This is called the coupon rate.
Annual Coupon Payment https://409ea80f398a1c3fbd56549661d747f7.safeframe.googlesyndication.com/safeframe/1-0-37/html/container.html
If a bond has a face value of $1,000 and made interest or coupon payments of $100 per year, then its coupon rate is 10% ($100 / $1,000 = 10%). However, sometimes a bond is purchased for more than its face value (premium) or less than its face value (discount), which will change the yield an investor earns on the bond.
Bond Yield Vs. Price
As bond prices increase, bond yields fall. For example, assume an investor purchases a bond that matures in five years with a 10% annual coupon rate and a face value of $1,000. Each year, the bond pays 10%, or $100, in interest. Its coupon rate is the interest divided by its par value.
If interest rates rise above 10%, the bond’s price will fall if the investor decides to sell it. For example, imagine interest rates for similar investments rise to 12.5%. The original bond still only makes a coupon payment of $100, which would be unattractive to investors who can buy bonds that pay $125 now that interest rates are higher.
If the original bond owner wants to sell the bond, the price can be lowered so that the coupon payments and maturity value equal yield of 12%. In this case, that means the investor would drop the price of the bond to $927.90. In order to fully understand why that is the value of the bond, you need to understand a little more about how the time value of money is used in bond pricing, which is discussed later in this article.
If interest rates were to fall in value, the bond’s price would rise because its coupon payment is more attractive. For example, if interest rates fell to 7.5% for similar investments, the bond seller could sell the bond for $1,101.15. The further rates fall, the higher the bond’s price will rise, and the same is true in reverse when interest rates rise.
In either scenario, the coupon rate no longer has any meaning for a new investor. However, if the annual coupon payment is divided by the bond’s price, the investor can calculate the current yield and get a rough estimate of the bond’s true yield.
Annual Coupon Payment
The current yield and the coupon rate are incomplete calculations for a bond’s yield because they do not account for the time value of money, maturity value or payment frequency. More complex calculations are needed to see the full picture of a bond’s yield.