Bond yields explained: Calculations, insights, and investment implications

Bond yields are a critical metric for evaluating fixed income investments. In the simplest terms, a bond yield is the return that an investor earns on a bond.

More specifically, bond yield is the annual rate of interest that an investor will potentially earn on a bond, expressed as a percentage of the bond's price. Bond yield is slightly different from the interest rate or coupon rate of the bond, because it also takes into account the current market value of the bond. Thus, bond yield helps you assess the actual return potential of the bond, given its market price, and unlike coupon payments, bond yield can change from time to time.

Understanding bond yields gives insight into an investment's potential benefits and risks. Higher yielding bonds indicate higher potential returns with higher risks, while lower yields suggest lower risk and potentially lower returns.

• Table of contents

1. Defining bond yields
2. How to calculate bond yields
3. Relationship between bond yields and bond prices
4. Other ways to measure bond yields
5. Insights gained from a bond's yield
6. Are higher-yield bonds always the better option?
7. How investors use bond yields in decision-making

Defining bond yields

When you purchase a bond, the bond issuer commits to paying you a certain rate of interest until maturity. This is also known as the coupon rate. A bond's yield, however, represents the rate of return you can expect to receive from owning the bond, based on the bond's coupon rate, length of time to maturity and current market price. The yield calculation enables a comparison between bonds with different coupons and tenures. The annual percentage yield provides a standardised measure of the bond's expected performance.

How to calculate bond yields

There are different types of bond yields. Let’s look at the current yield.

The formula for current yield is:

Bond yield = Annual coupon payment/current market price of bond * 100

For example, let’s assume you purchased a bond offering a coupon rate of 8% on the face value of Rs. 1,000. So, the annual coupon amount is Rs. 80.

If the current market price is Rs. 1,100, the bond yield will be: 80/1,100*1 = 7.27%
Yield = Rs.80 / Rs.1,100 = 7.27%

Relationship between bond yields and bond prices

To understand bond yield better, one must first understand the relationship between the market value of a bond and the prevailing interest rate in an economy. When prevailing interest rates in the economy rise, new bonds are issued at higher rates, making the older bonds with lower fixed rates less attractive. Similarly, when interest rates fall, the value of older bonds rises.

This is why bond yield is an important measure. While the coupon rate stays the same, the effective returns an investor will earn depend upon the present market value of the bond, which the bond yield calculation takes into account.

A bond's price and its yield are inversely related. As the bond's price increases, its yield decreases, and vice versa. This happens because the annual interest payment remains fixed. For example, if the bond's price rises to Rs.1,200, its yield falls to 6.67% (Rs.80 / Rs.1,200). If the price declines to Rs.900, the yield increases to 8.89% (Rs.80 / Rs.900).

Other ways to measure bond yields

While a bond's current yield provides a simple yield calculation, other methods offer more precision.

• Yield to maturity (YTM) factors in the present value of all future coupon and principal payments. It assumes you reinvest the interest at the YTM rate and hold the bond to maturity. YTM represents a bond's true potential yield over its remaining life.
• Yield to call calculates the bond's yield assuming it gets called or redeemed by the issuer prior to maturity. This often occurs when interest rates decline.
• Yield to worst determines the lowest potential yield under different call or redemption scenarios. It represents the minimum expected yield for calling the bond early.

Insights gained from a bond's yield

A bond's yield conveys important information about its risks and potential returns

1. Expected return on investment

• A bond yield shows how much return (interest income) you will potentially earn relative to the bond’s price.
• Higher yield means higher potential return (but possibly higher risk).
• Lower yield means lower return potential, often signalling lower risk or strong demand for bonds.

2. Interest rate expectations

• Bond yields move opposite to bond prices, which are affected by interest rates.
• If bond yields are rising, it often means interest rates are going up or are expected to go up.
• If bond yields are falling, it suggests interest rates are decreasing or are expected to do so.

3. Economic outlook

• High yields: Investors demand better return potential, which may indicate inflation concerns or higher risk.
• Low yields: Suggest that investors are seeking more relatively stable assets, often signalling economic slowdown or uncertainty.

Are higher-yield bonds always the better option?

Higher-yielding bonds are not necessarily more suitable investments than lower-yielding bonds. The higher yields compensate investors for taking on additional risks.

For example, corporate bonds pay higher yields than comparable Treasury bonds to account for the risk of company default. High-yield "junk" bonds may pay higher interests because they come from companies with relatively lower credit ratings and higher default risk.

Therefore, higher-yielding bonds are suitable only if you understand and can tolerate the associated risks and adopt a suitable investment horizon.

An intelligent investment decision balances the tradeoff between yield and risk based on your objectives, time horizon, and risk tolerance.

How investors use bond yields in decision-making

• Compare relative values of bonds based on coupon rate as well as market value
• Evaluate suitable bonds vs. other investments like fixed deposits. However, FDs offer fixed and guaranteed interests, unlike bonds, which are subject to market risk.
• Identify potential buying or selling opportunities when yields change substantially or diverge from benchmarks.
• Forecast future interest rate changes and economic conditions using yield trends over time.
• Calculate the true cost of capital on a loan or investment using the yield on debt.

Conclusion

A bond's yield calculation allows for an apples-to-apples comparison of expected returns across different bonds taking into account their present market value. It also provides meaningful insights into the bond's risks. Tracking yield trends over time highlights important changes in the overall market. Understanding the key concepts around bond yields, such as the inverse relationship between price and yield, helps investors make investment decisions aligned with their objectives.

FAQs:

What is bond yield meaning, and how is it calculated?

A bond's yield is the annual rate of return expressed as a percentage based on its annual coupon payment, and current market price. The formula is Annual Coupon Payment/Current Price *100. Higher yields represent more potential returns but also indicate higher risk.

What is the difference between current yield and yield to maturity (YTM)?

Current yield only looks at one year's interest income vs. purchase price. YTM calculates the bond's true yield over its full term, factoring in interest on interest and potential early call or sale.

How do interest rates affect bond yield?

When market interest rates rise, new bonds are issued at higher rates, driving down prices of older bonds so that their yields stay competitive. Falling interest rates cause the reverse.

What factors impact the bond yield of a company or government?

Key influences are credit quality, loan maturity, prevailing interest rates, inflation expectations, and overall demand for fixed income.

What is a high-yield bond, and is it riskier than other bonds?

High-yield bonds, also called junk bonds, are those that offer higher interest rate because their credit quality is rated below investment-grade by ratings agencies. Their lower credit quality means higher likelihood of default, so they offer higher interest rates to compensate for the added risk.

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