Bond Yield Definition
Yield is the amount of annual interest expressed as a percentage of principal, which helps investors compare different investments. It shows how much income investors will receive on their investment. There are several ways to calculate yield, or, put differently, there are several yields.
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Nominal Yield (Coupon Rate)
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Nominal yield is the amount of annual interest paid on $1,000 of face value. For example, a 5 percent coupon bond pays $50 in interest annually per each $1,000 of principal.
Current Yield
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Once issued, bonds trade in the secondary market. Their market prices are affected by interest rates, credit rating changes, issuers' financial state and general market conditions, and can be more or less than the face value (premium or discount), but the amount of interest, once expressed as a percentage, is set in dollars. A 5 percent $1,000 face value bond may sell for, say, $1,100. Since the interest payment remains the same, the current yield will be $50: $1,100 = 4.6 percent.
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Yield to Maturity
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An investor may buy a bond in the secondary market at a premium or at a discount but he will only get back the face value at maturity. He will also have collected less interest in absolute terms than someone who bought that same bond when it was first issued.
For example, an investor buys a $1,000 face value 5 percent coupon bond (paying $50 in interest annually) for $1,100 (at a premium), i.e. with a current yield of 4.6 percent. At maturity, the investor will get back $1,000, realizing a $100 loss. The bond has 5 years left until maturity. The $100 loss pro-rated annually is $20, which means that the investor will receive a net income of $30 from the bond annually. The average price of the bond is calculated by dividing the sum of the purchase price and the face value by 2--$1,050 in our example. The yield to maturity is the net annual income ($30) divided by the average price ($1,050)--2.9 percent in our example.
Yield to Call
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Many bonds are issued with a call provision, meaning that the issuer has the right to call, or redeem, the bond at face value or at a premium at some point before the maturity. For example, a 20-year 5 percent coupon bond may be called after five years at a price of 103 ($1,030 per each $1,000 of face value). Since the bond may or may not be called, the investor can be certain only about how much income she will have received by the call date, so she uses the yield to call to evaluate her investment using the above formula.
Zero Coupon Bonds
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Zero coupon bonds do not pay interest but are sold at a deep discount to the face value. The income an investor receives is the difference between the price he pays for the bond and its sale price or face value at maturity (whichever comes first). For example, an investor can buy a 20-year zero coupon bond for $500 and get its full face value--$1,000--at maturity. The difference--$500---is his return, which, expressed as an annual yield, is 5 percent.
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References
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