The bond yield is the amount of income earned by an investor each year, represented as a proportion of the bond price.
What is a Bond Yield?
When you purchase a bond, the amount of money you will get in the form of interest is a percentage of the bond issue price. This sum is constant. Bonds’ market value might fluctuate when they are exchanged. When their market worth fluctuates, the quantity of money to be paid to you varies as well. This is the bond’s yield.
Current yield = annual coupon payment / bond’s current market price
How does Bond Yield work?
A bond is a loan arrangement between a corporation and a government agency. The borrower commits to pay the original loan amount (also known as the “principal amount”) plus periodical interest payments on a future date (the bond maturity date) by issuing the bond. Interest payments, sometimes known as coupons, are often made on a yearly, semi-annual, or other regular basis.
A bond’s yield is often calculated as a percentage of the upfront investment or as a percentage of the bond’s current market value (current yield).
To trade at a premium – what does it mean?
Trading at a premium occurs when investors sell their bonds for a higher price than they paid for them. A bond’s price might grow or fall based on a variety of circumstances. As an example – the shift in interest rates.
To trade at a discount – what does it mean?
Trading at a discount is the inverse of trading at a premium; this happens when investors sell their bonds at a lower price than they initially purchased.
Coupon rate vs. current yield
Bond yields are frequently represented in one of two ways:
- The coupon rate is the interest payment on a bond expressed as a proportion of the initial investment. This interest rate is set at the time of bond issuance and remains constant during the bond’s life.
- The current yield, also known as the interest payment based on the bond’s current market price. Unlike the coupon rate, the current yield of a bond can change over time based on the bond’s market price, which fluctuates based on market conditions, changes in federal interest rates and other variables.
Why is the bond yield going up/down?
Bond price changes tend to follow a simple rule: when interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. This is due to the fact that higher interest rates frequently imply that an investor might get bigger interest payments on a freshly issued bond. Existing bonds with lower interest rates become less appealing as a result (this is why their prices may fall).
At the same time, interest rates are not the only factor that may affect bond prices (and, consequently, its yield). Here you can find some of other causes:
- Changes in bond demand or supply
- Changes in the bond issuer’s creditworthiness as a result of its financial state, economic market conditions, or other reasons.
- If the bond is withdrawn by the issuer (repays the bond before its maturity)
Can investing in bonds be detrimental?
Bonds are thought to be less hazardous than other forms of assets, such as stocks. Bonds, like all kinds of investing, carry the risk. Bond investors might lose money in a variety of ways:
- You sell your bond at a lower price than you bought for it (at cut-rate). Investors that hold the bond to maturity must presumably refund their initial investment in addition to the periodic coupon payments received over the bond’s existence. This, however, is not always the case. You may suffer losses if you have to sell your bond before it matures.
- The issuer may decide to stop paying interest on your bond. For example, if the corporation that issued the bond runs into financial difficulties, it may fail to pay interest or default.
- Not all bonds reach maturity; sometimes the bond’s issuer may retain the authority to redeem the bond before it matures. (These are known as revocable bonds.) As with any investment, it is critical to undertake preliminary research to understand the dangers and strategies to mitigate them.
What is the bond’s rating?
Many bonds and bond issuers, like individual borrowers, are awarded ratings based on their general creditworthiness (a measure of the borrower’s capacity to repay their loan). The bond rating informs investors about the possibility of the issuer repaying the debt in full. For this purpose, the Securities and Exchange Commission (SEC) has designated specific credit rating organizations called Nationally Recognized Statistical Rating Organizations (NRSRO).
These organizations examine the overall financial situation of many (but not all) bond issuers. Then the agency gives a bond rating or letter rating ranging from AAA or Aaa to D or without a rating. Bonds are often classified into two types:
- Bonds with ratings of BBB, bbb, Baa, or above are included in this category. They are often regarded as having a low or moderate risk.
- Non-investment grade bonds, commonly known as junk bonds or high yield bonds, have a substantially higher chance of default.
Remember that each NRSRO agency has its own set of standards, therefore the bond rating may differ in various agencies.
The impact of inflation
In general, inflation has the same impact on bond yields as interest rates. It’s important to keep in mind that when interest rates fall, bond prices increase; when interest rates rise, bond prices fall. When interest rates rise in response to rising inflation, bond prices fall, lowering the current return on bonds.
Bonds with longer maturities (those that will mature in the future) are more likely to lose value since there is more time for inflation to climb substantially. It’s one of explanations why certain bonds with longer maturities pay a greater interest rate than others.