Understanding bond yields is essential for assessing the potential risks and rewards of fixed income assets.
- The yield on a bond is the return you get on a bond over a period of time.
- There are several types of bond yields. These can be used to assess the risk and value of a bond.
- Bond yields are inversely correlated with bond prices. When prices go up, returns go down and vice versa.
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A bond yield is a numerical representation of the expected returns of a bind offers. There are several types of bond yields, each with their own calculations and use cases.
Generally speaking, investors use yields to determine whether a bond is a good investment – especially relative to other bonds. Bond yields can also be used to assess risk.
Thinking of investing in bonds? Here’s what you need to know about their returns.
How is the yield on a bond calculated?
There are many ways to calculate the yield on a bond. Among the most important are its yield to maturity and its yield to redemption.
Before we get there, it helps to understand the most basic bond yields: the coupon yield and the current yield.
The coupon yield – or coupon rate – is the interest you earn on a bond each year. For example, if you bought a bond for $ 100 and earned $ 5 in interest per year, that bond would have a coupon yield of 5%. The exact formula is:
Coupon rate = The annual credit interest of the bond / Original nominal value
The current yield is a reflection of the interest the bond earns in the current market. So in the example above, if the price of the bond you bought goes up to $ 110, the current yield would drop to 4.5%. You calculate the current yield by dividing the annual interest income by the current market price of the bond ($ 5 / $ 110 in this case).
Yields are highly dependent on interest rates. As Jeff Bryden, senior vice president and portfolio manager at RMB Capital, explains: “The market price of a bond changes as market interest rates fluctuate. Bond prices maintain an inverse relationship to changes in interest rates. “
Since bond prices also play a role in calculating yields, interest rates have a similar influence on yields as well. If interest rates rise, bond prices fall, pushing up yields. If interest rates fall, bond prices rise and yields fall. In short: Interest rates and bond yields tend to move in the same direction.
What are the different types of bond yields?
There are many types of bond yields, and each tells you something slightly different about a bond and the returns it has to offer.
Let’s take a look at some of the common returns investors consider:
- Current yield: Same as current yield – a bond’s earnings divided by its current market value
- Nominal efficiency: Same as coupon rate or coupon yield – the interest rate you will earn on a bond annually
- Yield to maturity (YTM): Shows the interest you will earn if you buy a bond and hold it until its maturity date
- Equivalent tax yield (TEY): Helps you compare which bonds are tax exempt and which are not; calculated by taking the yield on the tax-exempt bond and dividing by [one minus your marginal tax rate]
- Call Yield (YTC): A calculation of your long-term interest if you sell the bond before maturity; uses a “call date” – or the date you are entitled to sell the bond, along with the bond’s price for that day
- Worst return (YTW): Either the YTM or the YTC, whichever is lower; gives investors an idea of the lowest possible yields offered by the bond
- SEC yield: The expected return on a bond as determined by the Security and Trade Commission; based on historical data
According to Robert R. Johnson, professor of finance at Creighton University, yield to maturity is one of the most commonly used yields. “This is the annual rate of return an investor would earn if they bought the bond at today’s price and held it to maturity,” he says.
Bond yield relative to price
Bond yields and bond prices are inversely correlated. Like Tim Bain, President and Chief Investment Officer at Spark Asset Management, so says, “Think of a swing – or seesaw for those in the north. When one goes up, the other goes down.”
This is due to the way the returns are calculated. A current yield, for example, takes into account the current price of the bond. When that price goes up or down, it sends the return in the opposite direction.
Let’s look at two examples of current performance side by side:
|Obligation A||Bond B|
|Interest earned annually: $ 5||Interest earned annually: $ 5|
|Current price: $ 100||Current price: $ 500|
|Current yield: 5%||Current yield: 1%|
As you can see, the yield drops as the price of the bond increases. According to Bryden, price fluctuations are more likely on bonds with longer maturity periods. This can mean more volatile returns as a result.
What do bond yields tell investors?
Bond yields can be used in several ways. First, they can tell you how much you can earn on one bond versus another investment.
Bonds with higher yields, for example, offer more potential profits. Keep in mind, however, that while it can be tempting, high yield bonds also come with more risk.
“If a bond’s yield is higher than most other bond yields, it tells you that its risk is higher because investors will generally pay less for an investment that carries more risk,” says Michael Edesess, Partner director at M1KLLC. However, if that risk – the risk that the bond will default – does not materialize, then the bond will be worth more than the other bonds because it will pay a higher return. In other words, the greater the risk. is higher, the higher the price, and therefore the higher the yield. “
The financial report
Bonds are widely regarded as one of the safest investment vehicles. And the different returns on a bond can tell you a lot about how risky the investment is and what returns you can get from it.
If you are unsure of which bond or investment is best for you, consider contacting an investment professional or qualified financial advisor before doing anything.