Bond yield is the return you get after investing in a bond which is a debt instrument issued by the government or corporations, both public and private. It can also be understood as the expected earnings generated on your fixed-income investment over a specific time period. Bond yields are expressed as percentages or interest rates.
You are stating it simply when you lend your money to the government or to a corporation or any bond issuer that along with the principal value, provides you with interest on the amount you invested through the life of the bond.
What is a Bond Yield?
Definition: Bond yield is defined as the return you get on the investment in a bond. When you put your money in a bond, you are lending it to a bond issuer that offers you returns in terms of interest payments.
Yields on a bond can vary from bond to bond, making it an investment that needs some thought to be put into it. The most important thing about an investment is the return realized on it, and while a bond is a fixed-income instrument, the returns can vary highly.
Types of Bond Yields Calculations
Different types of yields that are worth of paying heed to
1. Coupon Yield
A coupon is nothing but a document that ensures a discount or a rebate on a particular commodity when you purchase it. When discussing a bond, the coupon rate is the rate of interest you regularly receive every few months (the period for receiving the interest is pre-decided).
Coupon Rate= Annual Coupon Payment/Bond Face Value
For example, if you have purchased a bond of the face value of $2000 and the coupon rate or annual rate is 20% paid annually for five years, you will receive $400 every year for five years, and at the ending, you will receive the principal amount or principal payments, that is $2000, on a particular date.
2. Current yield
The current yield of a bond, in mathematical terms, is equal to the Coupon Price upon the face value of the bond.
The current yield of a bond helps the investor understand the actual value of the bond in the market.
Current Yield= Annual Coupon Payment/Bond Price
3. Yield to maturity (YTM)
The yield to maturity of a bond is an assessment that helps compare bonds with different coupon rates and varying periods of maturity.
It can be understood as the internal rate of return that an investor earns after buying the bond today at the market price and assuming that they will hold the bond until maturity, plus all the principal and coupon payments will be made as per schedule.
The yield to maturity is calculated by adding the interest revenues you receive throughout the investment journey of your bond (assuming the reinvestment of the interest received at the value of the current yield) and adjusting the gains or losses made (if the bond was purchased at a discount or a premium).
Yield to maturity (YTM) = [(Face value/Present value)1/Time period]-1
- YTM < bond’s coupon rate – Market value of the bond will be greater than par value ( premium bond)
- YTM > bond’s coupon rate -Bond will be selling at a discount
- YTM = bond’s coupon rate – bond is selling at par
4. Yield to call (YTC)
Yield to call (YTC) also follows the same process as YTM but instead of including the number of months until the bond maturity occurs, you might opt for a call date and call price of the brand. YTC calculation checks the impact on a bond’s yield in case you call it prior to maturity.
5. Yield to worst (YTW)
Yield to worst (YTW) is the one that is lower in between YTM and YTC. is lower. In case you like to find out the most conservative potential return that you can get from a bond for every callable security, then you should do this comparison to find out YTW.
6. Yield reflecting broker compensation
It is the type of yield that is adjusted by the amount of commission or mark-up when you purchase the bond or mark-down or commission when you sell it alongside other charges or fees that you might be charged by the broker.
How does a bond’s return vary?
Many bond investors are puzzled that even bonds can be realized at different prices because the bond issuer fixes their return value according to the market forces way before the bond is issued.
The solution to this puzzle lies in debt and capital instruments. Bond, by nature, is a debt instrument that works like a loan. You lend your money for a particular period during which you receive interest payments.
This makes it a fixed-income financial instrument. What makes a bond a capital one is when it is exchanged before its period of maturity. When bonds are sold before they reach their maturity period, they go through a similar trajectory as other securities like shares.
Their prices fluctuate owing to the demand in the market. A capital gain goes on the bondholder’s books when they sell a bond at a price higher than the face value. Similarly, a capital loss comes into the picture when the bond is sold at a lower price.
The inverse relation between the Bond’s price and Bond yields
Surprisingly, the price of a bond and the yield that it provides are inversely related even though they both are considered as a good signal. If you’re thinking, how is this possible, don’t worry; the answer is pretty simple.
When observed from an investor’s point of view, a higher yield means a much more attractive investment which encourages the bond buyer to buy more bonds.
On the other hand, if you own a bond, you will want the yield to be lower because a lower yield ensures the bond prices to be higher, making the sale a comfortable situation for you.
Hence, in simple terms, it can be said that-
When the bond’s price goes up, the bond yield will go down and vice versa.
Influence of interest rates on bond yields
A bond’s yield depends upon many factors like face value, period of redemption, etc. But the most important of them all is the interest rate that exists at that time in the market. When the interest rates of bonds increase, they become more attractive for the investors than the original bond, which lowers the bond’s price.
If a bondholder wishes to sell their bond when the interest rates are higher than the coupon rate of the bond that they’re holding, they are forced to lower the price of their bond, which in turn increases the bond’s yield. On the other hand, if a bondholder desires to exchange their investment in return for cash when the interest rate in the market is lower than their coupon rate, they can enjoy a capital gain by increasing the price of their bonds.
This means that a higher interest rate translates to a high yield on the bond, and as the interest lowers, so does the yield, making the relation between the interest rate and the yield a direct one.
Comparing High-yield and Low-yield bonds
An investment should be made with the investor’s risk tolerance in mind. It is a secret to none that higher risk increases the chances of getting higher returns. When we talk about bonds based on the yield that they provide, the choice depends on the aim of the investor.
If high returns are expected from a bond, high-yield bonds can do wonders for the buyer, considering that they know the risk that comes along with it.
A bond might be regarded as a safe investment by those who frequently invest in the stock, but experts know that even investing in bonds can be risky as the government or the company that issued the bond can end up defaulting your investment.
If you’re looking for a low-risk investment, choosing a bond with a lower yield might be the best decision for you.
Reading a Treasury Yield Curve
The treasury yield curve comes into the picture while talking about bonds and interest rates.
It is a graph in which the key treasury bond data is shown for a particular trading day. In the graph, the interest rates run up the vertical axis, and bond maturity runs along the horizontal axis.
The slope of the yield curve will let investors know about the future interest rate changes and economic activity.
Typical treasury yield curves are upward sloping that suggests that securities that have longer holding periods will comprise higher yields, as you can see in the graph, yield or interest rates rise with the increase in the holding period or maturity.
With the help of the bond’s yield, investors know the return that they may get from the bond’s coupon (interest) payments.
A bond yield becomes essential when an investor performs the analysis of their investment. The buying and selling of bonds make it an instrument with varying prices depending on the yield that a bond delivers.
The compilation of different yield values that form a yield curve helps inform the investor about the market’s current situation and helps them make predictions for future investments.