What is Bond Yield?
Bond yield represents the return an investor realizes on a bond investment. There are two primary measures: Current Yield which is the annual coupon payment divided by the bond's current market price, and Yield to Maturity (YTM) which is the total return anticipated if the bond is held until maturity. YTM considers both coupon payments and any capital gain or loss at maturity.
Bonds trade at premiums or discounts to their face value based on interest rate movements. When market rates rise above a bond's coupon rate, the bond trades at a discount. When market rates fall below the coupon rate, the bond trades at a premium. Understanding yields helps investors compare bonds with different coupons and prices on an equal basis.
Examples
Example 1 - Discount Bond: Face: $1,000, Price: $900, Coupon: 5%, Years: 10. Current Yield: 5.56%. YTM: ~6.38%. Trading at discount since price < par. YTM > coupon rate.
Example 2 - Premium Bond: Face: $1,000, Price: $1,100, Coupon: 8%, Years: 5. Current Yield: 7.27%. YTM: ~6.23%. Trading at premium since price > par. YTM < coupon rate.
Example 3 - Par Bond: Face: $1,000, Price: $1,000, Coupon: 6%, Years: 8. Current Yield: 6%. YTM: 6%. Trading at par. Coupon rate equals both yields.
Frequently Asked Questions
What is the difference between current yield and YTM?
Current Yield only considers annual coupon income relative to current price: Annual Coupon ÷ Current Price. It ignores capital gains/losses at maturity. YTM is the comprehensive measure that includes both coupon payments and any capital gain or loss if held to maturity. YTM assumes all coupons are reinvested at the same yield rate. For comparing bonds with different prices and coupons, YTM is the superior metric.
Why do bonds trade at premium or discount?
Bonds trade at premiums or discounts based on interest rate changes since issuance. If market rates fall below a bond's coupon rate, that bond becomes more valuable - buyers pay a premium to get higher coupons. If market rates rise above the coupon rate, the bond becomes less attractive and sells at a discount. The price adjusts so that the bond's YTM aligns with current market rates for similar risk bonds.
Is higher YTM always better?
Not necessarily. Higher YTM often indicates higher risk. Corporate bonds with lower credit ratings offer higher yields to compensate for default risk. Always consider: Credit rating of issuer, Call provisions that might limit upside, Liquidity of the bond, Tax status (municipal vs taxable), Duration/interest rate risk. The best bond balances yield with acceptable risk for your portfolio.
How does inflation affect bond yields?
Inflation erodes the purchasing power of fixed bond payments. When inflation rises, investors demand higher yields to compensate, causing bond prices to fall (yields rise). Conversely, when inflation falls, bond prices rise (yields fall). This is why bonds are considered vulnerable to inflation risk. Treasury Inflation-Protected Securities (TIPS) adjust principal for inflation, providing protection.
What is duration and how does it relate to yield?
Duration measures a bond's price sensitivity to interest rate changes, expressed in years. Higher duration means greater price volatility when yields change. It's related to time to maturity but also considers coupon size - lower coupons mean higher duration. When yields rise, bonds with higher duration experience larger price declines. Investors match duration to their investment horizon to minimize interest rate risk.
Can bond yields be negative?
Yes, bond yields can be negative, and this has occurred in several countries including Japan, Germany, and Switzerland. Investors accept negative yields when they expect even worse returns elsewhere (like cash) or anticipate further rate declines (bond price appreciation). Central bank policies can also drive yields negative. Negative yielding bonds still pay positive coupons, but the premium paid over face value exceeds total coupon payments.
What is the yield curve?
The yield curve is a graph plotting yields of bonds with identical credit quality but different maturity dates. A normal yield curve slopes upward - longer maturities have higher yields. An inverted curve (short-term yields > long-term) often predicts recession. A flat curve suggests economic uncertainty. Investors use the yield curve to: Compare relative value across maturities, Predict economic direction, and Make asset allocation decisions between short and long-term bonds.