Securities Markets - Yield Terms
For the exam, you will need to distinguish between the three types of yield calculations for bonds: the nominal yield, the current yield and the yield to maturity.
- Nominal Yield: This is simply the yield stated on the bond's coupon. If the coupon is paying 5%, then the bondholder receives 5%.
- Current Yield: This calculation takes into consideration the bond market price fluctuations and represents the present yield that a bond buyer would receive upon purchasing a bond at a given price. As mentioned earlier, bond market prices move up and down with investor sentiment and interest rate changes. If the bond is selling for a discount, then the current yield will be greater than the coupon rate. For instance, a 6% bond selling at par has a current yield that is equivalent to its nominal yield, or 6%. A bond that is selling for less than par, or at a discount, has a current yield that is higher than the nominal yield.
The current yield formula is as follows:
|Current Yield = Annual Interest Payment
- For example, say the bond is currently at $920:
$60 = 6.5%
- Yield to Maturity: This measures the investor's total return if the bond is held to its maturity date. That is, it includes the annual interest payments, plus the difference between what the investor paid for the bond and the amount of principal received at maturity.
- Duration: While not technically a yield term, duration is an important concept to know. Duration is the primary measure of bond price volatility. It takes into account both the length of time to maturity and the difference between the coupon rate and the yield to maturity. Here are some of the most important facts about duration:
- The longer the duration of a particular bond, the more its price will fluctuate in response to interest rate changes.
- Duration is always equal to or less than the years to maturity of the bond.
- Duration can help to calculate the impact of interest rate changes on the price of the bond. For example, a bond with a duration of eight is likely to decrease 8% for every 100 basis points increase in market interest rates.
- Duration is a weighted average term to maturity.
- As payment frequency increases, duration decreases.