Table of Сontents
- Bond Yields Explained
- Types of Bond Yields
- How To Calculate a Bond Price
- When Bond Yields Rise or Fall
- Bond Yield Curves
- How Investors Use Bond Yields
- Bottom Line
When adding bonds to their investment portfolios, investors may feel more confidence if they have a better understanding of bond rates.
Bond Yields Explained
An investor who purchases a bond is effectively giving money to the bond’s issuer, who then promises to reimburse the investor with interest during the bond’s life and the principal at maturity. Municipalities, governments, and corporations all issue bonds to raise investment cash.
The return on investment in a bond, or yield, may be calculated in a number of different ways. But first, let’s examine what makes up a bond:
- Issue price: the cost at which a bond is sold by its initial issuer
- Par or face value: The value of the bond upon maturity; it also serves as the basis for calculating the bond’s interest.
- Coupon rate: the bond’s interest rate, which is expressed as a percentage of the bond’s face value; for instance, a bond with a face value of $1,000 and a coupon rate of 5% will pay $50 in interest yearly.
- Coupon dates: the times a bond issuer makes interest payments; interest on most bonds is paid semi-annually.
- Maturity date: the day the bond’s face value is paid to the bondholder by the issuer.
Since bonds are bought and sold on the open market after they are issued, it is crucial to understand that the price of a bond and its face value is not always the same. If the price of a bond is above or below face value, the yield will be different from the coupon rate.
Types of Bond Yields
The various bond yields include:
1. Current Yield
Bonds are frequently bought back before they mature, either at a premium or a reduction to their face value. When this occurs, the current yield and coupon rate diverge. The current yield is calculated using the following formula:
Annual Coupon Payment / Bond Market Price = Current Yield
For instance, if a bond with a $1,000 face value and a 5% coupon rate were to trade for $1,040, its current yield would be.05/1,040.00 = 4.8 percent.
If the identical bond were to trade at $1,020 the next day, its coupon yield would be.05/1,020.00 = 4.9 percent.
A new bond’s coupon rate and current yield won’t be equal unless it is purchased at par and kept until it matures.
2. Yield To Maturity (YTM)
The bond’s yield to maturity, which takes into account all coupon payments, represents the investor’s anticipated return after holding the bond until its maturity date. When expressing yield to maturity, yearly percentages are used. In contrast to current yield, which gauges the bond’s worth now, yield to maturity assesses the bond’s value in the future. Yield to Maturity is calculated using the following formula: [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)
Bonds with a yield-to-call feature can be redeemed or called in by the bond’s issuer before to the bond’s maturity date. The first date on which the bond might be called is used in YTC calculations in order to account for the impact of a call before maturity on the bond’s yield. The call price, which is typically the bond’s face value, is paid to investors together with any current interest that has accumulated. The YTC calculation formula is as follows:
The yield to call is equal to [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)
In order to calculate the bond equivalent yield, it is necessary to take into account the fact that most bonds pay interest in two semi-annual installments. If the coupon payments were made yearly, the YTM and BEY would be identical, but semi-annual coupon payments result in a different YTM. The BEY is calculated using the following formula: BEY = YTM * 2.
Going from a semi-annual to an annual YTM, the BEY does not account for the time value of money (TVM). When contrasting two bonds with various payoff frequencies, it is a helpful metric.
5. Effective Annual Yield (EAY)
A figure known as effective yearly yield accounts for compounding. Reinvestment of interest payments is a given. For a semi-annual coupon payment, the formula for calculating EAY is:
Effective Annual Yield = ((1 + YTM /2)squared) – 1
EAY formula (Wendorf)
6. Yield To Worst (YTW)
Yield to worst, or YTC, is the lesser of the two yields that represent the worst-case scenario for a bond’s prospective return, particularly for callable bonds.
YTM or YTC = Yield to Worst (whichever is lower)
How To Calculate a Bond Price
If you know the bond yield but not the bond price, you may use the yield equation to find the price in all bond yield computations. Fortunately, there are a number of online calculators, such as Omni Calculator, Calculate Stuff, and Dqydj, that let investors figure out the yield and price of a bond.
When Bond Yields Rise or Fall
Because a bond’s price represents the cost of the income it offers through its monthly coupon payments, its price swings in the opposite direction of its yield. All types of existing bonds appreciate in value as interest rates decline because they have larger coupon rates than new bonds and may be sold at a premium on the secondary market. If interest rates increase, investors may be able to get a greater coupon rate on new bonds, but the value of old bonds decreases. They trade at a discount and their prices drop.
Let’s examine a connection that has:
- A face value of $1,000
- A coupon rate of 5%
- A maturity date of 10 years
The bond yields $50 in interest each year. Let’s say that new $1,000 bonds have interest rates of 7.5 percent. This bond would be in direct competition with new bonds that pay $75 yearly rather than $50 if an investor wanted to sell it before it matured. The investor must drop the price to a level where the coupon payments plus the maturity value match the 7.5 percent return in order to draw purchasers.
The bond’s price would increase if interest rates dropped, say from 5% to 3% because the coupon payment would become more enticing.
Bond Yield Curves
The bond yield curve (Wendorf)
In a typical graph of bond yields, the y-axis represents interest rates and the x-axis represents maturities. Bonds with longer maturities often offer higher interest rates to make up for the longer lockup period for investors. Macroeconomic factors and Federal Reserve policy decisions have an impact on bond yield curves.
The yield increases as the maturity term lengthen, as indicated by the yield curve’s upward slope. The rate for a 30-day bond is 2.55 percent, while the rate for a 20-year bond is 4.8 percent in the fictitious chart. When the yield curve flattens, investors may expect to earn roughly the same return from both short- and long-term bonds.
If the yield on short-term bonds increases
How Investors Use Bond Yields
Bond yields are used by investors to calculate the expected returns of certain bonds. Bond traders examine several bond categories with the same or comparable yields, such as corporate or government bonds, and they search the yield curve of a bond for indicators of future market activity and interest rates.
Bottom Line
Trading in bond markets requires an understanding of bond yields. Bond yields can also be used to predict future changes in the bond and equities markets.
