- 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.
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A bond yield is a numerical representation of the expected returns a specific bond offers. There are several types of bond yields, each with their own unique calculations and use cases.
Generally speaking, investors use yields to determine if 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.
How is a bond yield calculated?
There are many ways to calculate a bond’s yield. Some of the most important include its yield to maturity and its yield to call.
Before we get to those, 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 annually from a bond. For example, if you bought a bond for $US100 ($AU133) and earned $US5 ($AU7) 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 is a reflection of the interest the bond is earning in the current market. So, in the above example, if the bond you purchased goes up in price to $US110 ($AU147), the current yield would drop to 4.5%. You calculate current yield by dividing the annual interest earnings by the current market price of the bond ($US5 ($AU7) / $US110 ($AU147) 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.”
Because bond prices also play a role in calculating yields, interest rates have a similar influence on these too. 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.
What are the different types of bond yields?
There are many types of bond yields, and each one 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 yields investors consider:
- Running Yield: The same as the current yield – earnings from a bond divided by its current market value
- Nominal Yield: The same as coupon rate or coupon yield – the rate of interest you’ll earn annually from a bond
- Yield to Maturity (YTM): Indicates the interest you’ll earn if you buy a bond and hold it until its maturity date
- Tax-Equivalent Yield (TEY): Helps you compare bonds that are tax-exempt and those that are not; calculated by taking the yield on the tax-exempt bond and dividing by [one minus your marginal tax rate]
- Yield to Call (YTC): A calculation of your long-term interest if you sell the bond prior to maturity; uses a “call date” – or the date on which you have the right to sell the bond, as well as the bond’s price for that day
- Yield to Worst (YTW): Either the YTM or the YTC, whichever is the lowest; gives investors an idea of the lowest possible returns the bond offers
- SEC Yield: A bond’s expected yield as determined by the Securities and Exchange Commission; based on historical data
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 yield vs. price
Bond yields and bond prices 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: $US5 ($AU7)||Interest earned annually: $US5 ($AU7)|
|Current price: $US100 ($AU133)||Current price: $US500 ($AU667)|
|Current yield: 5%||Current yield: 1%|
As you can see, the yield goes down as the bond’s price goes up. According to Bryden, price fluctuations are more likely on bonds with longer maturity periods. This can mean more volatile yields 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 stand to earn on a bond compared with another investment.
Bonds with higher yields, for example, offer more potential profits. Keep in mind, though, that while this can be tempting, high-yield bonds also come with more risk.
“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 M1KLLC. “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.”
The financial takeaway
Bonds are largely 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.