What Are Bond Yields?
Bond Yields Definition
Bond yields are interest rates paid on bonds as a proportion of the price paid for the bond. To calculate bond yields, investors look at prices, payments and the time until bonds expire.
Every bond has a yield, and bond yields are one of the most commonly discussed topics in financial markets. However, to understand what bond yields are, one has to understand what a bond is.
Essentially, bonds prove that people who have borrowed money from a lender will repay that amount of money with interest over a specified period [1].
In other words, someone who would like to borrow money from someone else may want to issue a bond. When you want to buy a bond as an investment, you essentially give a loan to the bond giver or issuer.
This ‘someone could either be a government or any other organisation [2].
In essence, the bond is a piece of paper that states the details of this borrowing agreement.
The borrower, after a period, will return the amount they have lent - and frequently, with interest. This interest payment - the amount of profit the lender or investor has made - will then be calculated as a percentage of the money lent - thus forming the yield.
Bonds, the bond yield, and the bond prices are critical parts of finance linking to many other aspects of the financial markets - whether this might be the equities market or the real estate market [3].
Table of Contents
Read on to find out how bond yields work, how we can measure bond yields, and how
Bond Yields Explained with Examples
Take, for example, the US Treasury security, which shows that the owner of this piece of paper – the bond – will be paid $1,000 within a year.
For the sake of this example, say that you are buying the bond from the US Treasury itself – the government. Of course, you could also purchase this piece of paper from someone else, but that is not what we want to look at right now.
Imagine that you buy the bond that pays you $1,000 per year, for $950. You hand over the $950, and the government will give you this security right here.
Fast forward one year. You have this piece of paper in your possession, and what happens?
Assume that the bond says: ‘The holder of this security will get $1,000’. At the end of the maturity period, the US Government will have to give you your $1,000 back.
When you take a step back and consider how the money has changed hands, you would probably realise two things: 1) you have just lent the government $950; 2) you have just received $1,000 in return – one year later (after maturity).
Putting this in terms that we usually associate with lending money and borrowing money – how much profit and interest did you just get? You just lent $950, and you received $1000. You just made a $50 profit – within a year.
Bringing out the maths, let’s say that we divide.
(1,000 - 950)/ 950 = 5.3%
In other words, you have lent out 100%, and you have received 105.3% in return – and a 5.3% interest.
You have received your money back.
Can you imagine, now, that all of a sudden, many people want to buy this government security – and now the price goes up. The demand is higher now and drives the prices up.
Instead of being $950, imagine that it is now $980. Now, you would get $1,000 after a year as that is the face value, and if you paid $980 at the beginning instead of $950, then a year later, when you get the $1,000 back, that will only be:
(1000 - 980)/ 980 = 2.04%
In this situation, you lent out $980, received $1,000 after a year, and made a profit of $20: an annual interest of 2.04%.
Therefore, with the $950 price, you are essentially lending the government at 5.3%. At $980, you are lending the government money at 2%.
Bond yield rate changes all happen because of supply and demand: when the price of the Treasury security goes up because many people want to buy the bond, the yield – or the interest – that you are getting on your loan goes down.
Regarding bond yields, it is important to note how much money you have paid for it initially.
If you lend out $980 and get $1,000 back, you only get 2% on your money as interest or yield. If you lend out $950 and get $1,000 back, you get 5.3% on your money as interest.
This numerical example shows the inner and inverted workings of the yields; the higher price the investors pay for a bond (because of higher demand), the lower the bond yield; the lower the price the investors pay, the higher the bond yield. This was done by displaying the mechanisms of a zero-coupon bond: a bond without periodic coupon payments.
How Bond Yields Work
Here is the relationship between interest rates and bond prices. The critical point is that a bond is a fixed interest security [4].
Fixed interest securities are when the government (or any organisation, for that matter) issues a bond, which is typically sold to the financial markets by a country’s central bank (such as the Fed in the US, the European Central Bank based in Germany, the Bank of England, etc.).
The bond itself pays a fixed annual amount of interest, known as the coupon on the bond. Coupons can be paid in any currency – it could be paid in dollars, pounds, euros, etc. However, the most essential aspect of the bond is that this amount is fixed.
However, the yields of the bonds can vary and can change from one moment to the other.
The best way to think about the yield on a government bond is to see it effectively as the interest rate on the bond.
The yield on a fixed interest bond will vary ‘inversely’ with the bond’s market price. In other words, they move in separate and opposite directions [5].
When the prices of the bonds are going up, the bond yield will fall. When the bond prices are going down, the yield will increase.
Most bonds have higher maturity periods, as well as periodic payments: the coupons.
We now can find out how to calculate and use the different bond yields to make better investment decisions.
How Do You Calculate Bond Yields?
Coupon Rate
The rate of the coupons as a percentage of the bond’s face value can provide a good indication of the profitability of the bond for the investor. In a sense, the coupon rate is the interest rate paid on a bond, depending on when the bond is issued until it expires. Coupon payments are represented as a percentage of the face value of a bond [6].
The face value is the price at which the bond was issued. In other words, it is the amount of money that the bond issuer has borrowed. Quite simply, the coupon rate is the rate of interest that is paid on a bond.
Take, for example, a bond with a par value of $5,000 and a coupon rate of 5%; the total annual coupon payments would be $250 per year.
($5,000/100) x 5 = $250
A typical bond would have payments every six months, meaning that the bond will pay out $125 every six months.
Of course, investors would tend to prefer bonds with higher coupon rates.
Say that an investor buys a bond with a face value of $1,000, and you receive two $25 payments per year. The coupon rate is the percentage you receive in one year – the investor received $50, which is 5% of the $1,000 he paid. The bond in question, therefore, has a coupon rate of 5%. The coupons never change, regardless of for what price the bond trades. You will always get $50 per year.
Therefore, the coupon rate is calculated as:
Coupon Rate = Annual coupon payment/ Par value
Current Yield
What the previous numerical example shows is essentially the current yield [7]. To standardise this numerical example, one could see that the calculation conforms is:
Current yield = annual coupon payment/ bond price
In other words, the current yield shows what the investor or lender will earn if he buys a bond and holds it for one year.
The previous numerical example overlooked one crucial aspect. Many bonds include coupon payments; as mentioned earlier – these are fixed periodical payments.
Consider an example where Bob wants to buy a bond for $1,000 with a $100 annual coupon payment. He then divides the $100 by the total price for the bond, the $1,000, and finds that his current yield is 10%.
However, bond prices constantly change due to market conditions, whether financially or economically.
As a result, Bob does not know immediately how much his actual return will be, as the prices may go up and down.
The actual return, in this case, will then depend on how long he holds the bonds and their price when he sells them again.
Say that he sells the bond after two years for $750, while he has earned $200 during the two years, he held the bond.
Since he sold it for $250 less than the original price, he lost $50 – as he earned $200 in return.
The current yield, in this case, calculates approximately what he might earn, which helps him decide whether to invest in the bonds at all.
One could see here that the coupon rate could be different from the current yield. The coupon rate involves the coupon payments themselves – these do not change, and neither makes the amount of money eventually paid after maturity – the par or face value.
Yield to Maturity (YTM)
Investors might want to know more to contemplate better whether a bond is going to be worth it. In this case, Bob will need to consider the yield to maturity (or YTM). YTM shows the return or profit he may expect when he holds the bond until it matures at the end [8].
The bond’s YTM is displayed and discussed as an annual rate, and it accounts for what all of the bonds’ future coupon payments are worth today – in current values.
Bob needs to know the bond’s market price, the par value, the coupon interest rate, and the time to maturity. He enters these numbers into a computer programme or a calculator that assumes that all coupon payments are reinvested at the same rate as the bond’s current yield of 10%. The equation used for this is as follows:
yield to maturity = (c + [FV-P]/T)/ ([FV-P]/2), where:
C = Coupon payment per period
FV = Face value
P = Current price paid for the bond
T = Time until the bond matures
With this information, say that Bob still thinks about buying the bond with $1,000 face value. Instead of holding it for one year, the bond’s maturity period is five years.
The YTM is a complicated measure but gives Bob a better idea of his potential returns and lets him compare what he could earn from bonds with different maturities and coupons.
Effective Annual Yield (EAY)
Now, the thing is that many coupons are paid per period – which is frequently every six months/half a year. Investors holding bonds for more extended periods may want to know their actual yield per year [9]. In the case of two payment periods per year, one would calculate the effective annual yield as:
EAY = (1+[(yield to maturity)/periods)])^periods - 1
What Bond Yields Mean for Retail Investors
Bond yields show the return that investors can get from the bond’s coupon payments. The article has been demonstrated that the yield can be calculated without considering the time value of money, or using complex methods such as yield to maturity.
Bond yields could then be high or low [10].
Higher Yields
Higher yields mean that the bond issuers owe more interest to investors, but it may also be a sign of greater risks; after all, fewer people want to lend money to the issuers. For instance, it could be that investors have less faith in the government or the organisation. That would be one possibility.
Another possibility would be that bond yields do not always necessarily lead to high profits, but rather to a steady cash flow over time.
Some people may consider other investments more worth it, and as a result, the demand for bonds decreases over time – leading to higher yields again.
Lower Yields
In contrast, lower yields show that the demand for bonds is high. After all, the prices are pressed higher, pushing yields lower again. A common reason might be the fear of the economy slowing, leading to investors flocking to a safe and steady investment over time: bonds.
Article Sources
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