A bond is a financial instrument that offers fixed and predictable returns. By issuing bonds, the bond issuers are borrowing money, and therefore, bondholders act as creditors to the issuer. There are various terms related to bonds that one needs to understand before investing in them, and one such is bond yield. Bond yield means what the bondholder will get by investing in a bond. Here is a detailed description of bond yields.
Bond Yield Meaning
Bond yield refers to the returns the bondholder will receive for investing in a particular bond. Bondholders’ return partially depends on coupon payments, which refer to the periodic interest income obtained as a reward for holding bonds. Coupon rates are predetermined and usually remain the same throughout the bond’s life. High-risk bonds may offer higher yields, which means larger interest payments, and vice versa.
The bondholders receive the bond’s face value at the end of the bond’s life. However, one may buy bonds at par value, discount (at a price lower than par value) or premium (at a price higher than par value) as they trade in the secondary market. Therefore, the prevailing market price of bonds also affects the bond yield.
How to Compute a Bond’s Yield?
Bond yield calculation involves two variables, annual coupon payment and current bond price. The annual coupon payment is the product of the coupon rate and the bond’s par value. Usually, the annual coupon payment remains the same throughout the bond’s life, where its price may change.
Here is the bond yield formula.
Bond yield = Annual coupon payment/ Bond price
For instance, a bond with a face value of ₹1,000 promises to pay 10% interest annually, and the current bond price is ₹1,200.
Annual coupon payment = ₹1,000*10%= ₹100
Bond yield = ₹100/₹1,200 = ₹0.0833 or 8.33%
The bondholder would receive an 8.33% yield at the current price.
What is Bond Equivalent Yield (BEY)?
The bond equivalent yield is a metric that helps to calculate the annual percentage yield for bonds offered at a discount and paying semi-annual coupons. BEY considers the bond’s face value, purchase price, and maturity in the calculation. Here is the formula to calculate
BEY = [(Face value – Purchase price) / Purchase price] * 365/d
Where d = days left for bond maturity
For instance, an investor purchased a bond for ₹80, which would offer ₹100 at maturity. The bond will mature after 180 days. Here is the BEY calculation.
BEY = [(₹100 – ₹80) / ₹80] * 365/180 = 0.25*2.03 = 0.507 or 50.75%
Relationship Between Bond Yield and Price
The bond yield and bond price tend to have an inverse relationship. The bond yield rises when the bond price falls, and the bond yield falls when the bond price rises.
For instance, an investor buys a bond with a face value of ₹1,000, which offers an 8% annual coupon rate and will mature in seven years. It means the annual coupon payment would be ₹80 per bond, and the current bond yield is 8% (₹80 / ₹1,000). Here are two scenarios representing the relationship between yield and price.
If the bond price rises
If the interest rates in the market fall to 6%, the price for this bond will rise as it offers a relatively higher coupon rate (8%). Further, if the price of a bond rises to ₹1,100, the yield will be
₹80/₹1,100 = 7.27%
If the bond price falls
If the interest rates in the market rise to 10%, the price for this bond will fall as it offers a relatively lesser coupon rate (8%). Thus, if the price of a bond falls to ₹900, the yield will be
₹80/₹900 = 8.89%
What does a Rise in a Bond’s Yield Mean?
A rise in a bond’s yield may look attractive at first. The bond yield usually rises when the interest rates in the market rise and go above the coupon rate the bond offers. Rising bond yields indicate that investors are selling their bonds, assuming that higher rates would lead the bond price to decrease. The investors selling bonds at that time may need to face capital loss.
Frequently Asked Questions
A bond’s yield describes the return the bondholder will get for investing in a particular bond. Higher yield suggests that bondholders will get larger interest payments and vice versa. Low-yield bonds may be less risky than high-yield bonds.
Low-yield bonds may be better for investors seeking lower risks and lower returns assets. In contrast, high-yield bonds are better for investors amenable to more risks in exchange for higher returns.
Coupon yield refers to the periodic interest income bondholders are likely to receive as a reward for holding a particular bond. Further, the division of the sum of annual coupon payments by its par value results in coupon yield.
The current yield represents the expected annual income from the bond based on the current bond price and is calculated by dividing the annual return by the bond’s current market price.