What is Bond Yield? Types and Meaning
Bonds are considered as a relatively safe form of investment. Buying a bond essentially means lending your money to the government or the company that issues the bonds. The issuer promises to pay you interest at regular pre-decided intervals once you subscribe to the bond issue. Bonds are hence classified as debt instruments that offer a fixed income. There are various factors that determine the bond yield, or the returns generated from a bond. The concept of bond yield is quite perplexing and through the course of this article we seek to help you grasp the fundamentals of the same.
What is Bond Yield?
A bond’s yield is the return you are bound to earn after investing in a bond. Just like fixed deposits offer interest on the investment, bonds also provide a fixed rate of return, called the “coupon rate.”
Bond yield can simply be understood as one of the most fundamental measures of Bond Return. The coupon rate is defined as a percentage of the face value (principal amount) of the bond and remains unchanged till it matures.
When you divide the coupon payment of the bond by its face value, you get the coupon rate. This further can be understood as one of the most basic ways to determine the yield of a bond. However it is prudent to note that this method of yield calculation holds good only if the bond is held throughout the tenure up until the maturity date.
Bonds in practice can be sold at par, premium or discount to their face value. When it is not sold at par, it becomes prudent to understand some of the basic concepts pertaining to bond prices while calculating bond yield.
Let us now try to understand the prerequisites on Bond Prices for Yield Calculation.
Relation Between Bond Price and Yield
Bond Prices are by virtue inversely proportional to Bond Yields. The rationale behind the same lies in the fact that when the market cost of borrowing increases, pre-entered bond contracts offering relatively lower returns become less lucrative investment avenues. The imbalance in Supply and Demand due to increase in divestment on account of availability of better investment alternatives, forces down the prices of pre-existing bonds.
Due to this relationship and the fact that interest rates are also subject to some degree of volatility, it becomes prudent for investors to compare bond prices in the context of promised risk adjusted return.
Ideally, you must indulge in buying bonds at the lowest price for a given risk adjusted return.
Types of Bond Yields
In the following segment, let’s discuss the different types of bond yields:
1) Current yield
As mentioned above, bond price and yield are inversely proportional.
Suppose you purchase a bond with a par value of Rs. 1,000 that matures in five years and the coupon rate offered on the same at onset is 10% per annum.
The bond is expected to earn your Rs.100 a year for the next five years. If during this period, the market rate of interest or the cost of borrowing rises above 10%, The price of your bond will decline. This is because if the interest rate goes up to 12%, the existing bond will still offer an interest rate of 10%, and thus appear to be a relatively less lucrative investment alternative.
The consequence of the above mentioned is the market price sliding down from the face value of Rs.1,000 to say Rs. 833.33.
On the flip side, if the market rate of interest goes down, the price of the bond you own is bound to increase on account of being a more lucrative investment alternative promising higher risk adjusted returns.
In both of the above discussed scenarios, the consideration given to coupon rate of the bond offer is relatively less as the yield is no longer solely dependent on the coupon rate. The variance of price from the par value is the underlying reason for the same.
The yield on such bonds wherein the subscription price differs from the par value is calculated by dividing the annual coupon payment on the bond by the current market price of the bond.
Current Yield = Coupon Payment Per Annum/Bond’s Current Price
The above illustration is highly simplified in order to facilitate easy comprehension. In practice the bond’s unique term structure complicates, interest rate movements etc complicate the computation of Current Yield.
2) Yield to maturity
To understand what yield to maturity (YTM) is , you need to revisit the relationship between bond price and yield. The YTM of a bond is basically the overall return you can expect from the bond investment until it matures from the time of subscription.
It means that you do not sell the bond in the secondary market. Instead, you hold the asset till it matures. Thus, the yield to maturity accounts for all the projected future cash inflows till the maturity date, including the interest payouts and the bond value at maturity.
Following up on the example above, the bond you purchased at a face value of Rs. 1000 for five years with a 10% coupon rate will be worth Rs. 927.90 to match the new YTM at a 12% rate of interest Sounds complex right? Let us simplify it for you. The revised market rate of interest is 12% and to match the same the price of the Rs.1,000 face value 10% coupon rate bond dips to Rs. 927.90. The Yield to Maturity on the bond priced at Rs.927.90 with a Coupon Rate of 10% is 12%.
3) Yield to call
There is a certain category of bonds wherein the issuer can initiate redemption by investors/ settlement prior to maturity. These bonds are known as “Callable Bonds”. There are however certain terms and conditions that the issuer has to comply with prior to exercising the “call option”, for instance the issuer cannot exercise the call option for a pre-fixed period of the tenure referred to as the “Lock-in”.
Please note that only the issuer has the right and not an obligation , to call the bond. When the current interest rates drop below the coupon rate of the bond, the probability of the issuer exercising its call option increases. Because now the issuer can offer new bonds at a lower rate of interest. This is similar to refinancing your loans so you can make lower monthly payments. Yield to call can thus be defined as the return you generate as a bond owner if you hold the asset till the issuer calls it.
Effects of Increasing Bond Yields in India
Bond Yields are primarily dictated by the Repo Rate set by the Reserve Bank of India. Raising the bond yield implies increased cost of borrowing for corporations. In a sense it makes them worse off. However, the investors are better off since they are now empowered to earn higher rates of return. RBI mainly tries to increase the interest rates in order to reduce the liquidity in the economy as a measure to curb inflation.
On the other hand, the RBI might be motivated to reduce the interest rates when they want to increase overall production and consumption in the economy.
Bond Yield vs Interest Rate
|It is the annual return an investor will earn if the bond is held until maturity.
|It is the interest amount investors receive for every bond they hold.
|Does it change or remain fixed?
|bond yield changes with bond price.
|The interest rate of most bonds is fixed until maturity. Floating interest rates change as per a predefined formula or schedule.
|Which is more important for an investor?
|Bond yield is more important than the interest rate if you invest to grow your money.
|The interest rate is more important than the bond yield if you want to earn a stable income via interest payments.
|How to get the highest bond yield/interest rate
|Search for bonds with a lower price than the face value to get a high bond yield. The bigger the gap, the higher the bond yield.
|To get a high-interest rate, you will have to take on “credit default risk” by investing in bonds with low credit ratings (BBB and lower). Lower-rated bonds have higher interest rates to attract investors.
If you are interested in being a genuine bond investor, it is crucial to understand what bond yield is and the factors that influence the rise and fall of yields. Bonds can be an ideal instrument to diversify your portfolio and safeguard your investment from an array of risks. Bond Yield is however not the only factor you would need to consider. It is prudent for you to gauge the creditworthiness of the bond issuer through the rating assigned, compare the risk adjusted returns of the bond of interest with other comparable investment alternatives etc.
What can I infer from higher Bond Yields?
Higher yield means a higher rate of return. But higher bond yield indicates that the issuer owes a large interest payment to the investors. It may also be considered a sign of risk if the creditworthiness of the issuer is in question. That is why low rated bonds offer higher yields.
Are high-yield bonds better than low-yield bonds?
Investing in bonds depends on your financial objectives and risk appetite. Bonds with a low yield can be preferred if you are looking for a relatively risk-free investment. You can opt for bonds with higher yields if you have greater risk tolerance. But prior to making this choice, it is prudent to probe into why the offered yield is high. It can sometimes be attributed to tenure as well.
What are some common types of bond yields?
Current yield, yield to maturity, and yield to call are some of the common types of bond yields.