What is Bond Yield?

Introduction

The financial market can be a risky affair. Amidst the high-risk investment options, investors and borrowers often get perplexed about managing their finances in a safe manner. Thankfully, bond yield renders them an opportunity of making a safe investment. 

A bond yield is a simple return on the investment that an investor expects after investing in a bond. But if you are learning about bonds and bond yield for the first time, confusion is inevitable. In this context, we will help you understand this in an easier manner. 
 

What Is Bond Yield?

A bond yield is a return on investment that is anticipated by the investor. This is so because it helps them receive a lump sum for the investment they made during the term to maturity. Since this bond yield comes with the total interest and principal that the investor will obtain, it is an important term to them. 

When the investor buys the bond for the first time after its issuance, it is known as the “primary market.” This means the first price that is paid by the investor for the bond relies on diverse essential factors. This may include the bond term, the rate of bonds that are similar to this one in the marketplace, and the size of the interest payments that were promised. These factors put together help estimate the right amount of the bond yield. 
 

Understanding Bond Yield

Before we dive any further into bond yield, let us unleash prior information about bonds. 

A bond is basically a loan that occurs between an investor and the borrower. Naturally, the investor is the one placing the loan, while the borrower is the one receiving it. But this only occurs for a determined period of time within which regular interest payments must be made to the investor for providing the loan. 

The time from which the investor provides the bond till the time the borrower pays out the entire loan is known as the term to maturity. Generally, Government and Corporate bonds are the two main types of bonds. But what is critical to note is that unlike a regular bond, here, the bond is eligible to be traded among other investors too. This indicates that it comes with a market rate. 
So, whatever principal amount and interest payments can be obtained from this bond by the investor is termed bond yield. Generally, this is always equivalent to the coupon rate. But one must remember that one can buy a bond at its face value at a good premium rate. In certain cases, they may even buy it at less than its face value which means they will get it at discounted rates. So, the yield of the bond will differ accordingly. 
 

What is the Relationship Between the Price of a Bond and Its Yield?

In simple terms, both bond price and yield may seem different, but they are somehow inversely related to one another. Look closely, and you will notice that when the bond price shoots up, the yield goes down and vice versa. If you already know the bond yield meaning, let us help you understand this relationship with a few examples. 

An investor bought a bond at face value worth $2,000. This amount is supposed to mature in six years. In the meantime, the coupon rate will be 20%. But the bond pays 20% with a $200 interest on a yearly basis. This means that if the interest rate escalates more than it already is, the bond price will eventually drop down in case the investor plans on selling it. 

But if the interest rate shoots up to nearly 22%, a coupon of $200 can still be earned. However, this would not be very pleasing to investors who can purchase the bond with an interest rate of $220. This means that the investor can choose to decrease the price so that the original $2,000 can be sold. As such, both the maturity value and coupon rate may be equal to a yield of 22%.

On the other hand, if the interest rates fall, the price will shoot up. This will happen because the coupon payment will be more impressive. This means the more rates fall, the higher the price of the bond.
 

What Is The Yield Curve?

The yield curve depicts the yield on bonds that have occurred during the distinctive term-to-maturity periods. Basically, it is estimated for every type of government bond whenever the term of maturity remains. Here’s a short example to help you understand better. 

The yield is estimated in terms of each government bond when there is only a single year left until the term to maturity is complete. Then, this value is placed against the X-axis on the Y-axis. Similar cases occur on the yield bond where there are three years remaining until term to maturity is estimated. Then, it is placed on the y-axis. 

When the yield curve is related to government bonds, it is known as risk-free. You may ask why it is called so. The simple answer to it is that the government has to pay back on time after borrowing in their own currency. This means the government issues low-yield bonds. But when you look into other bonds, especially corporations, they naturally have a higher yield. This is because corporate bonds are far riskier than government bonds for any investor. 

This may occur because corporations may or may not pay the investor the lump sum of interest and principal by the determined period of time. In this case, it is known as a default.
 

Yield To Maturity

When the bond is held until the term to maturity occurs, an investor can expect a return on their investment. This is what is called yield to maturity. It also indicates that during this time, the investor will not trade the bond in the financial market. Instead, the investor will hold the bond as long as its maturity date takes to arrive. 

So, whatever cash flows will occur till the time of maturity is considered in the yield to maturity. This includes the interest payments as promised too. This means that yield to maturity is that sum of money where the cash flow that is occurring at the moment is equal to that of the price of the bond that prevails. Once you have understood the bond yield definition, this will be easier for you to comprehend. 

In a synopsis, the yield to maturity is in alignment with the interest rate of the existing value of the bond’s future cash flows. Maturity value and coupon rate are included in these future cash flows. With a bond yield calculator, you can make accurate estimations about this on time. 
 

Bond Equivalent Yield

There are lots of bonds where one pays an interest rate nearly two times a year. This is done either on a half-yearly basis or a semi-yearly basis, depending on the agreement between both parties. This is where the equivalent bond yield comes into action. Here is the formula for this type-

Bond equivalent yield = [(Face value – purchase price) ÷ Bond price] x (365 ÷ the amount of time until the term to maturity occurs)

Financially speaking, a bond equivalent yield is a set metric where investors are allowed to estimate the yearly percentage yield related to fixed-income securities. So, even if these investors are temporary players that make payments on a yearly, quarterly, or monthly basis, the bond equivalent yield is what it is. 

This means now investors can also choose to run comparisons between the traditional income securities with the bond equivalent yield. As a result, they are able to make more mindful decisions and create a robust fixed-income portfolio for themselves. 

When you use the bond equivalent yield formula, it can guide you in approximating what the discounted bond can end up being on a yearly basis. 
 

Effective Annual Yield

When the interest payments are invested all over again on a bond, it is called effective annual yield. This is done by the person who is holding the bond. So, the total yield that can be obtained by the investor is known as an effective annual yield. This is different from the nominal yield. Here, the power of compounding is undertaken on investment returns to make the right estimations. 

So this helps bondholders to make estimations regarding their yields on bonds. But the only disadvantage of using this type of yield is that it assumes that the coupon payments can be invested again in another form of vehicle that is paying a similar rate of interest. This indicates that effective annual yield works under the assumption that the bonds are being sold at par. 

When you divide the payment of the coupon using the persisting market value of a specific bond, you can derive the effective annual yield. Let us take an example- 

Consider an investor who is holding a bond with $2,000 as face value. At the same time, they are paying a coupon of 10%. This is being done on a semi-annual basis in August and September. This means they are likely to obtain (10%/2) x $2,000, which will occur twice a year. 
 

How Do Investors Utilize Bond Yields?

Bond yields can be implemented for a range of analyses. The process of buying and selling bonds by traders may occur in terms of different maturities. This will help them to leverage the yield curve where the interest rates will have equal credit quality. However, the maturity rates will differ distinctively. 

By looking at the yield curve, one can derive a clear idea of the future interest rate modifications and how the investment is likely to perform in the coming time. Apart from this, they may also help take a peek into the distinctive interest rates as per the diverse bond categories that there are. 

Most investors are more inclined towards high-yield bonds. Although these bonds may come with a good amount of risk, they also come with better returns that can be profitable at the end of the day. But the only risk is that the government or the corporation that is providing this yield will create a default on its debts. 

Although it is difficult to say whether high-yield bonds are a bad or a good investment, they come with their pros and cons that the investor needs to map out as per their risk appetite. But buying high-yield bonds can also help diversify the portfolio in the end. 
 

Are High-yield Bonds A Better Investment Than Low-yield Bonds?

This is adjacent to our last paragraph, where we discussed that it is quite difficult to conclude whether the former is a good or a bad investment. But whether it is better than low-yield bonds depends on the investor and their risk appetite. 

If the investor is barely a beginner in this field, it is best for them to choose a low-yield bond. Although low-yield bonds do not bring very high returns, they come with minimal risks. That is why they can be good for starters. 

But for those who are okay with taking high risks, a high-yield bond can be a sound investment opportunity. This means high risks with high returns. Thus, it all depends on how far the investor is willing to take a risk for the returns they expect. Accordingly, they can choose one that matches their risk appetite and preference.
 

Conclusion

If you are an investor, you must be well-acquainted with your understanding of bond yields. Having sufficient knowledge of the bond yield formula and using it to make accurate estimations can also help you substantially in the long run of existing in the financial markets. 

The knowledge of bond yield charts and all the other details we have listed above can also help you make more mindful decisions when making investments in this sector. That is why it is best to refer to this content whenever you are perplexed in the field of bonds.