What Is Bond Yield?
For any corporate or government bond, yield indicates the return on invested capital in percentage terms. It relates the bond’s rupee price to its cash flows. These cash flows consist of i) coupon payments and ii) the return of principal when the bond matures.
The yield you can earn on a bond depends on whether you purchased the bond for more than its face value (at a premium) or less than its face value (at a discount). Higher yields, which are common with longer-maturity bonds, mean that investors are owed larger interest payments. They also indicate greater risk in that bond. Thus, the riskier an investment, the more yield investors demand.
Suppose you buy a 10-year bond of Rs.10,000 that pays a yearly interest of Rs. 500. Its coupon rate, which is also known as the coupon yield, is calculated as:
Bond Face Value
The coupon rate is the simplest way to calculate yield since it only depends on the bond’s face value and annual coupon payment rate.
In our example, the bond’s face value is Rs.10,000, and it pays out a yearly interest of Rs.500. Therefore, its coupon rate or coupon yield is calculated as (500/10,000) = 5%.
This rate is established when the bond is issued and does not change during its lifespan. Thus, for your Rs.10,000 investment, you will earn returns at the coupon rate of 5% during the entire 10-year maturity period of the bond.
Current Market Price
If you buy a new bond at par and hold it until it matures, your current yield at maturity will be the same as the coupon yield. However, if you purchase the bond from the secondary market, your current yield will not match the coupon yield but will depend on the bond’s price.
For the same example above, suppose the bond price in the secondary market falls to Rs.6,000. If the coupon rate remains the same (5%), your current yield will now “fall” to 8.33%.
These calculations notwithstanding, the current yield and the coupon rate are incomplete calculations for a bond’s yield. This is because they do not consider the time value of money or other factors like the bond’s maturity value or payment frequency. Here’s where other calculations like yield to maturity (YTM), yield to call (YTC), and yield to worst (YTW) come in.
What Is Bond Price?
A bond’s price is the sum of the present value of each of its cashflows. Cashflows are all present-valued using the same discount factor, aka yield. The price depends on how much you will earn from the bond over a certain time period. To calculate the price, you will have to compare today’s rates (the discount rate) on similar bonds, as well as the present value of remaining payments and the bond’s face value.
When you buy a bond at issuance, its price is the same as its face value. Moreover, its yield will match its coupon rate. So, if the bond pays 5% interest for 10 years, then that’s exactly what you will get for the next 10 years, assuming you hold the bond till maturity. When the bond matures, you will get back its face value.
The bond’s market value may change over its 10-year lifespan. However, the value is of no interest to you – unless you decide to sell it. If you do, you will have to consider the bond’s market price and annual coupon payment to calculate your current yield (see the previous section).
The Inverse Relationship Between Bond Yield and Price
When a bond is issued at par value, its yield equals the coupon rate. The yield is its rate of return considering changes in price and after discounting the bond’s cashflows at prevailing market rates.
Bond yield and price are inversely related. Thus, as the price goes up, the yield decreases, and vice versa. This relationship exists because the bond’s coupon rate is fixed, which requires the price in secondary markets to change to align with prevailing interest rates in the market.
Suppose you buy a bond with a face value of Rs.1,000, a maturity period of five years, and a 10% annual coupon rate. In this case, your coupon yield will be Rs.100, which you will earn as annual interest payouts.
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Frequently Asked Questions
What are the key takeaways from this article?
For any corporate or government bond, yield indicates the return on invested capital in percentage terms. It relates the bond’s rupee price to its cash flows. These cash flows consist of i) coupon payments and ii) the return of principal when the bond matures.
Who should read this article?
This article is designed for retail investors, first-time bond buyers, and anyone looking to understand fixed income investments in India.
How does this relate to my investment portfolio?
Understanding these concepts helps you make informed decisions about asset allocation and build a diversified investment portfolio.
