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- A bond yield is the return you get for a bond over a specific time period.
- There are several types of bond yields. These can be used to evaluate a bond's risk and value.
- Bond yields are inversely correlated to bond prices. When prices rise, yields fall, and vice versa.
A bond yield is a numerical representation of the expected returns one of these securities offers. There are several types of bond yields, each with their own unique calculations and use cases.
Generally speaking, investors use yields to determine whether a bond is a good investment — particularly compared with other bonds. Bond yields can also be used to evaluate risk.
Are you considering investing in bonds? Here's what you need to know about their yields.
Defining bond yield
Expected return
A bond's yield is a figure for its expected returns. In other words, it represents one of the major incentives that an investor has for purchasing such a financial instrument in the first place.
Armed with this information, an interested party can evaluate a bond to determine whether it represents a prudent investment.
A percentage of face value
There are many different kinds of yields, which have varying definitions and are calculated in different ways. Investors can benefit significantly from knowing how to calculate bond yields.
In all cases, yields are expressed as a percentage of the bond's face value (also known as par value), which is the price the owner would receive by holding one of these securities to maturity.
How bond yield works
Bond price and yield
It is important to understand the relationship between bond price and yield, which are inversely correlated. As Tim Bain, president and chief investment officer at Spark Asset Management, puts it: "Think of a see-saw — or teeter-totter for those in the north. When one goes up, the other goes down."
This is due to how yields are calculated. A current yield, for example, factors in the current price of the bond. When that price goes up or down, it sends the yield in the opposite direction.
Let's look at two examples of current yield side by side:
| Bond 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 goes down as the bond's price goes up. According to Jeff Bryden, senior vice president and portfolio manager at RMB Capital, price fluctuations are more likely on bonds with longer maturity periods. This can mean more volatile yields as a result.
Factors affecting yield
Interest rates, the issuer's credit rating, a bond's time to maturity, and the demand for fixed-income instruments all impact a bond's yield.
Yields are highly dependent on interest rates. The market price of a bond changes as market interest rates fluctuate. Bond prices maintain an inverse relationship to changes in interest rates.
If interest rates rise, bond prices fall, which sends yields higher. If interest rates decrease, bond prices rise and yields decline. In short: Interest rates and bond yields tend to move in the same direction.
Another consideration is term to maturity, meaning the amount of time left until the issuer repays the investor. Generally, bonds with longer times to maturity pay higher yields. In other words, short-term bonds pay lower yields than long-term ones.
One factor that has a major impact on a bond's yields is the credit rating of the issuer. Major credit ratings agencies provide companies and governments with credit ratings that attempt to determine how likely they are to pay back their debt.
These ratings range from investment-grade (very likely to pay back debt) to junk (less likely to pay back debt). Generally, a government with a low credit rating, for example, will need to provide a greater yield to entice investors to purchase its bonds. Likewise, a government with a high credit rating will not need to pay a high yield in order to draw the interest of investors.
"If a bond's yield is higher than most other bond yields, that tells you that its risk is higher because investors will usually pay less for an investment that carries more risk," says Michael Edesess, managing partner at M1K LLC. "However, if that risk — the risk that the bond will default — doesn't materialize, then the bond will be more valuable than other bonds because it will pay a higher yield. In other words, the higher the risk, the lower the price, and therefore the higher the return."
Types of bond yields
Coupon yield
The coupon yield — or coupon rate — is the interest you earn annually from a bond.
For example, if you bought a bond for $100 and earned $5 in interest per year, that bond would have a 5% coupon yield. The exact formula is:
Coupon rate = The bond's annual interest earnings / Original face value
Current yield
The current yield provides a more immediate evaluation of what a bond is paying, as it is calculated by dividing its current value by its annual interest payment.
Yield to maturity
Yield to maturity is the overall amount that an investor receives by purchasing a bond and holding it to maturity. To obtain this yield, an investor must receive all coupon payments and also have their principal repaid.
Calculating yield to maturity involves receiving regular coupon payments and then reinvesting them at the same yield that the bond is offering currently.
As a result, yield to maturity increases as interest rates push higher, and it falls as interest rates decline.
Interested parties can determine a bond's yield to maturity using various calculators available online.
According to Robert R. Johnson, professor of finance at Creighton University, yield to maturity is one of the most often-used yields. "It's the annual rate of return an investor would earn if she buys the bond at today's price and holds it to maturity," he says.
Bond yields: conclusion
Bonds are frequently considered to be one of the safest investment vehicles out there. And a bond's various yields can tell you a lot about how risky the investment is and what returns you may see from it.
If you're unsure which bond or investment is best for you, consider reaching out to a qualified investment professional or financial advisor before making any moves.
FAQs
Bond yields are important because they help investors evaluate bonds as potential investments. In addition, they allow investors to compare different bonds.
Generally, rising interest rates cause bond yields to increase and prices to decline.
A higher bond yield is not always better, as it could signal that the issuer is at a greater risk of not making its payments.
You can find information on bond yields on many different places, including the bond issuers', brokers', and financial websites.
Determining a bond's yield to maturity is a complicated matter, but it is something you can do using an online financial calculator.
