A bond’s yield is the investor’s return for holding the bond. Many factors affect the yield that an investor will receive from a bond such as:
- Current interest rates
- Term of the bond
- Credit quality of the issuer
- Type of collateral
- Convertible or callable
- Purchase price
An investor who is considering investing in a bond needs to be familiar with the bonds nominal yield, current yield, and yield to maturity.
A bond’s nominal yield is the interest rate that is printed or “named” on the bond. The nominal yield is always stated as a percentage of par. It is fixed at the time of the bond’s issuance and never changes. The nominal yield may also be called the coupon rate. For example, a corporate bond with a coupon rate of 8% will pay the holder $80.00 per year in interest.
8% x $ 1,000 = $ 80. The nominal yield is 8%
The current yield is a relationship between the annual interest generated by the bond and the bond’s current market price. To find any investment’s current yield use the following formula:
Annual Income / Current Market Price
For example, let’s take the same 8% corporate bond we used in the previous example on nominal yield and see what it’s current yield would be if we paid $1,100 for the bond.
Annual Income = 8% x $ 1,000 = $ 80
Current Market Price = 110% x $ 1,000 = $ 1,100
Current Yield = $ 80 / $ 1,100 = 7.27 %
In this example we have purchased the bond at a premium or a price that is higher than par and we see that the current yield on the bond is lower than the nominal yield.
Let’s take a look at the current yield on the same bond if we were to purchase the bond at a discount or a price which is lower than par. Let’s see what the current yield for the bond would be if we pay $900 for the bond.
Annual Income = 8% x $ 1,000 = $ 80
Current Market Price = 90% x $ 1,000 = $ 900
Current Yield = $ 80 / $ 900 = 8.89%
In this example we see that the current yield is higher than the nominal yield. By showing examples calculating the current yield for the same bond purchased at both a premium and a discount, we have demonstrated the inverse relationship between prices and yields. That is to say that prices and yields on income producing investments move in the opposite direction. As the price of an investment rises, the investment’s yield falls. Conversely, as the price of the investment falls, the investment’s yield will rise.
Yield To Maturity
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