An Overview of Bond Yields
It doesn’t matter how long you’ve been investing — every investor could benefit from having bonds as part of their portfolio. Just like stocks, a bond’s value can vary from its face value depending on the economy and how stable the issuer of the bond is. Learn more about bond yields, their benefits, and the different methods you can use to calculate them.
- Bond yields are the profits that an investor can expect as a return on their bond investment.
- One of the most popular ways to calculate bond yield is the coupon rate, which is dividing the annual payment by the face value of the bond.
- Bond yield and bond price work like a seesaw — as one goes up, the other goes down and vice versa.
- Interest rates play a major role in how much investors are willing to pay for bonds and, therefore, how much you may be able to sell yours for.
What Are Bond Yields?
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Simply put, bond yield is how much an investor expects to get as a return on their bond investment, expressed as an annual percentage. For example, a 5% yield means that you can expect a 5% return on average each year. Put another way, a bond yield is the profit you’ll make from your investment.
- From the issuer: This is a common way to purchase bonds, and investors who go this route usually plan on holding on to the bond until maturity.
- On the secondary market: Another way to purchase bonds is through another investor who has already purchased the bond and is ready to sell it off to someone else.
When you buy a bond as an investor, you are essentially lending money to the company or individual who is issuing the bond. In return for your investment, the bond issuer agrees to pay you interest on the bond for as long as the bond is in existence, plus the face value of the bond once it hits maturity.
Bond yields are important because they show how strong the current stock market is and how stable and popular the United States dollar is. Bond yields that are decreasing mean that bond prices are going up due to an increase in demand.
How to Calculate Bond Yields
Although there are factors that can affect the bond price and, ultimately, your return, you’ll still want to calculate a bond yield before deciding if this is the best move for you to make. You can also calculate the bond yield at any time that you own the bond to help you decide whether you should sell it to another investor. The most popular and simplest way to figure out a bond yield is to calculate the coupon rate. To do this, divide the coupon payment by the face value of the bond.
For example, imagine that a bond has a face value of $2,000 with interest or coupon payments of $200 per year. That makes the coupon rate 10%, calculated by dividing the $200 annual payment by the $2,000 face value of the bond ($200 / $2,000 = 0.1 = 10%). In this example, the bond has an annual yield of 10%.
Calculating the coupon rate is the most straightforward way to determine the bond yield, but because you can purchase a bond at a premium (higher than face value) or a discount (less than face value), the yield can ultimately change. In these cases, you may be better off calculating the current yield, which takes into account the bond’s price and its interest payment. This method of calculation tends to be more accurate because you are basing it off of the bond’s actual price rather than its value.
There are additional ways to calculate yield as well, like the time value of money and compound interest. Here are the different ways to calculate yield depending on how complex you’re willing to go to get a more exact calculation:
Yield to Maturity (YTM)
The yield to maturity calculation takes the following into account: the coupon rate, the years left until the bond reaches maturity, the value of future coupon payments (the time value of money), the compound interest you’ll earn if you choose to reinvest your interest payments, and the difference between the bond’s face value and its price.
As you may guess from the name, the yield to maturity calculation is mostly used when an investor is planning on keeping the bond until maturity, which is very common. A YTM calculation allows investors to figure out which securities are worth holding on to for the long-term.
Yield to Call (YTC)
Yield to call is similar to YTM, but it doesn’t take into account how many months are left until a bond matures in the same way. Instead of making that a part of the calculation, YTC uses a call date and call price. YTC is used to understand how a bond’s yield would change if the bond is called before the maturity date. When using this method, you’d want to use the first possible bond call date to make sure you get the absolute base amount you could expect.
Yield to Worst (YTW)
An investor may use the YTW calculation if they want to be the most conservative with their potential return numbers. It represents the lowest possible yield you could get on your bond, assuming that the bond operates as it should and doesn’t go into default. Because bonds have retirement dates, the YTW calculation represents the return if your bond is retired at the earliest allowable date.
Bond Equivalent Yield (BEY)
It’s typical for a bond issuer to pay their annual coupon in two semi-annual payments, and the BEY accounts for this. The simplest way to calculate the bond equivalent yield is to double the YTM, but keep in mind that the BEY does not account for the time value of money like the YTM does.
Bond Yield and Price
No matter how you choose to calculate yield, one of the most important things to remember is that there is a relationship between yield and price that resembles a seesaw — when one goes up, the other goes down. When the bond price rises, the yield falls, and as the bond price lowers, the yield goes up.
The bond price is important, especially when you trade bonds with other investors. A bond’s price is equivalent to what an investor is open to paying for the bond, expressed as a percentage of face value.
For example, assume one bond has a face value of $10,000. Throughout its existence to maturity, there may be three different prices that investors are willing to pay for it and, therefore, three bond prices. Because the price is a percentage of face value, one investor may be willing to pay 90 for the bond ($9,000), another 98 ($9,800), and yet another 105 ($10,500).
Price and Interest Rates
Interest rate plays a significant factor in how much an investor is willing to pay for the bond. You’ll probably find that if current interest rates are higher now than when the bond was first issued, you can expect the price of the bond to be lower. That’s because, with higher interest rates, bonds with higher coupon rates are issued, meaning that the older bonds aren’t as enticing to investors. Getting them at this lower price may be an investment strategy you’re willing to take on.
On the other hand, interest rates can also decline, and the existing bonds will typically increase in price. In this scenario, an investor may be able to sell their bond for more than they paid for it. That’s because other investors look for bonds with a higher coupon payment because they’ll get paid more.
For example, imagine a $10,000 bond has a coupon rate of 7% when you first purchased it. However, while you’re the holder of the bond, the interest rate may rise to 9% or fall to 5%. Three different scenarios can take place:
- The coupon rate and interest rate are equal (7%): The price of the bond is at 100, meaning an investor is willing to pay the full price of $10,000 to own the bond.
- The interest rates rise: If the interest rates rise to 9%, investors may be less interested in purchasing your bond because it was issued earlier, and with interest rates where they are, they can buy a brand new bond (and therefore, reap the benefits of higher interest payments) instead. These investors will probably be looking to buy your bond at a discount because of this, so the price of your bond may drop to 90, meaning the investor is willing to pay 90% of the price, or $9,000 ($10,000 x 0.9).
- The interest rates drop: If the current interest rate drops to 5%, it means that investors can purchase brand new bonds and only get 5% on those bonds. Therefore, they are willing to pay more money for your bond because your coupon rate is higher and they’ll get paid more. The price of your bond may then rise to 105, meaning the investor is willing to pay you $10,500 ($10,000 x 1.05).
As you can see, purchasing bonds can be as complicated or straightforward as you’re willing to make it. While purchasing bonds may be a great investment move for you, it’s usually best to speak with a broker or adviser who can help you figure out which bond yield benefits you the most. Then, you can decide which bonds to add to your investment portfolio with the hope of getting a great return on your investment over a period of time.