What Is Required Yield?
Required yield is the required rate of return that a fixed-income investment must provide in order for that investment to be worthwhile. The required yield is determined by the market and it sets the precedent for how current bond issues will be priced.
For instance, if prevailing market interest rates are, say 5% for bonds of a particular riskiness, and a similarly risky bond's fixed coupon rate is 4%, it must trade at an appropriate discount in order to achieve the equivalent required yield of 5%.
- Required yield is the return on a fixed-income security that would make it at least an expected break-even investment.
- The required yield will be reflected in a bond's market price existing as a discount or premium relative to similar bonds.
- A bond's relative riskiness will also change the required yield to investors, with more risky securities demanding a higher yield to make it worthwhile.
Understanding Required Yield
Required yield is the minimum acceptable return that investors demand as compensation for accepting a given level of risk, especially in terms of fixed-income securities such as bonds.
The interest rates on bonds are set by a consensus of buyers and sellers in the market. How high or low the yield is will be based on a particular bond interest rate, which will determine the price of the bond in the market. For example, if the required yield increases to a rate that is greater than that of the bond's coupon, the bond will be priced at a discount to par. In this way, the investor acquiring the bond will be compensated for the lower coupon rate in the form of accrued interest. If the bond is not priced at a discount, investors will not purchase the issue because its yield will be lower than that of the market. The opposite occurs when the required yield decreases to a rate that is less than that of the bond's coupon. In this case, investor demand for the higher coupon will drive the bond's price up, making the bond's yield equivalent to market yield.
Required yield is also the net yield required by the marketplace to match available expected returns for financial instruments with comparable risk. The yield required for a low-risk bond such as a Treasury security will be lower than the yield required for a high-risk bond such as a junk bond.
Required Yield and YTM Calculations
When calculating the price of a bond, the required yield is used to discount the bond’s cash flows to get the present value. An investor’s required yield is useful for estimating whether or not a bond is a good investment for an investor by comparing it with the yield to maturity (YTM). While the yield to maturity is a measure of what a bond investment will earn over its life if the security is held until it matures, the required yield is the rate of return that a bond issuer must offer to incentivize investors to purchase the bond.
The required interest rate on bonds at any given time will greatly affect the YTM of bonds. If market interest rates increase, the yield to maturity of current bonds will be lower than the new issues. Likewise, if prevailing interest rates in the economy decrease, the YTM on newer issues will be lower than that of outstanding bonds.