What is Bond Yield?
Bond yield is the return an investor receives from purchasing a bond and is determined as a percentage of the bond's price. A bond yield meaning can also be defined as how much an investor can earn from a given bond. The annual payments from investing in a bond are divided by the bond price to determine the bond yield. Calculating bond yield helps investors compare different bonds and make an efficient decision.
Understanding Bond Yield Better
Determining the value of bond yield depends on various factors, such as compounding interest payments and time value. This leads to complex calculations like bond equivalent yield and yield to maturity. Let us look at these two concepts in detail to understand what the meaning of yield and the significance it carries.
Yield to Maturity (YTM)
Yield to maturity measures the total return investors achieve if investors carry the bond until maturity.
It includes all possible cash flows of the future while evaluating the YTM.
Suppose a company issues bonds with the following terms:
Face value = Rs. 1,000
Coupon rate = 10%
Periodicity of payments = Once a year
Maturity = 5 years
Date of bond issue = 01 September 2020
Assuming you purchase the bond when it is issued, you are buying it at face value. The bond will pay a coupon of 10% on 01 September 2021.
If the bond sells at a discount to the face value, it implies that the coupon rate is less than the current interest rates. As a result, the bonds became less attractive, which pushed their prices downwards. In this case, the YTM would be higher than the coupon rate. Similarly, if the bond sells at a premium to the face value, it implies that the current rate of interest is less than the coupon rate. This indicates that the coupon rate is higher than the YTM.
Bond Equivalent Yield (BEY)
The bond equivalent yield measures the annual percentage yield on fixed-income securities. While selecting various fixed-income investments, investors can use BEY to compare whether a particular investment is better or worse than other investments.
BEY = [(Face value -Purchase price) / Purchase Price]* (365/d)* 100
Where d denoted the days until maturity.
The Link Between Bond Yield and Bond Price
Bond yields typically have an inverse relationship with bond prices, i.e. higher bond prices are linked with lower yield and vice versa. Let us understand how.
| Suppose your bond has a face value of Rs. 1000 and a coupon rate of 10%. You earn 10% of 1000 as coupon payments, i.e. Rs. 100. |
| Scenario I: Bond trades at a discount |
Suppose the bond price is Rs. 700 in the secondary market. This implies that the bond trades at a discount of Rs. 300 to its face value.
Yield = coupon rate/bond price, i.e. 100/700 = 14.28% |
| Scenario II: Bond trades at a premium |
Let us assume the bond price in the secondary market increases from Rs. 700 to Rs. 1300. The bond now trades at a premium to its face value.
Yield = 100/1300 = 7.69% |
Conclusion
Bonds can serve as the ideal financial instruments to diversify your portfolio. However, before you begin investing, understand the basics, such as what is the meaning of bond, factors influencing bond prices, the rise and fall of bond yields, the relationship between bond prices and yields etc., to achieve maximum return on your investments.