Yield from a financial angle is the annual percentage return earned from the investment made on a security. For example, a 6% yield means that the investment averages a 6% return each year. Yield is the most popularly used tool to measure the return from a bond – be it a government bond or a corporate bond.
Now, bonds are becoming popular instrument for investment. Hence, bond and valuation of bonds are important from macroeconomic angle.
For understanding bond, we should know about bond. A bond is a debt security issued by an entity to mobilise funds. When a bond is subscribed a person, he shall pay the money denominated in the bond. For example, Rs 1000 for a newly issued Rs 1000 bond that is paid back at the maturity period.
How yield works in the case of bonds?
The simplest way to understand yield is the situation where an investor purchases bonds directly from the issuer at face value. Here, if the coupon interest rate is 7%, the yield is 7% (coupon yield). But rarely investors purchase bonds directly from the primary market. Bulk of the bond trade are held in the secondary market as we can see in the case of shares.
In the secondary market, the price of the bond will be different from the issue price in the primary market. Often a Rs 1000 bond (implies a face value of Rs 1000) will be available in Rs 980 or sometimes at Rs 1200 depending upon the interest rate of the bond vis a vis the interest rate in the economy and other factors. Still, if the investor is going to sell the bond at the maturity period, which is suppose five years from now, the bond’s maturity value will be Rs 1000.
So, when you purchase a bond from the secondary market, the price will be different from the face value of Rs 1000. As we so, the price may be Rs 950 (you are getting the bond at a discount of Rs 50) and Rs 1100 (you are getting the bond at a premium of Rs 100).
Now, when you purchased the bond at Rs 950, your investment is Rs 950 for a bond that will give you a face value of Rs 1000 after five years (but we are not going to hold this bond for the next five years). This means that with an investment of Rs 950, you are getting Rs 70 as interest payments (interest rate of 7%). This Rs 70 is the yield for you. But remember, your investment is just 950. Now, how much is this Rs 70 as a percent of Rs 950 (your investment)? It is 7.36% (and not 7%). The yield of the bond increased.
Why the bond’s yield increased?
The bond’s yield increased because it price came down from Rs 1000 to Rs 950.
Why the price of the bond decreased?
This is because the interest rate in the market (interest rate charged by banks etc.) increased to say 8% or 9% like that. But the interest rate you are getting from the bond remains at 7% (of Rs 1000). In this context, the bond became unattractive for the investors. To make it attractive, the bonds’ price in the secondary market came down to R 950 to accommodate a low interest rate. In this situation, the investors are ready to purchase that bond because its price came down.
We thus know that with a premium or discount (in the secondary market), yield differs based on the purchase price (here Rs 950). Yield is a function of a security’s price (Rs 950) and coupon interest rates (here 7% r Rs 70).
But yield fluctuates according to a number of factors, including global markets and the domestic economy. But the most important determinant is the interest rate prevailing in the market.
Different types of yield
There are several ways to calculate yield, but basically, the relationship between price and yield remains constant: the higher the price an investor pays for a bond, the lower the yield, and vice versa.
Calculation of yield
While calculating yield from a bond, a number of factors should be considered, including the purchase price and the coupon interest rate.
- The coupon interest payments paid by the issuer,
- Capital gains (or capital losses) when the bond is sold (you sell it at a higher price or lower price) and
- Income from reinvestment of the interest payments you received.
There are three popular methods to estimate the yield used by investors to measure the return from investing in a bond:
- i) Coupon Yield: The coupon yield is simply the coupon interest payment expressed as a percentage of the face value. Coupon yield is the nominal interest payment on security like Government bond. Coupon yield thus does not consider additional factors.
Coupon yield = Coupon Payment / Face Value.
For example, consider the Face Value of a bond is ` 100 and the coupon interest rate is ` 8.24. Here, the Coupon yield = 8.24/100 = 8.24%.
- ii) Current Yield: The current yield is the coupon payment as a percentage of the bond’s purchase price. Here, the bondholder may be purchasing the bond at a premium or discount so that his investment is not equal to the face value. The current yield also does not consider factor like reinvestment of the interest income received periodically.
Current yield = (Annual coupon rate / Purchase price) X100.
iii) Yield to Maturity: Yield to Maturity (YTM) is the expected rate of return from a bond if it is held till its maturity time. YTM is the yield that investors consider while investing in a bond. Yield to maturity requires a complex calculation. It considers the following factors:
- Coupon rate—Here, the higher a bond’s coupon interest rate, the higher will be its yield.
- Price – The higher a bond’s price, the lower will be its yield. Here, an investor has to pay a higher price for the same fixed return.
- Years remaining until maturity – Yield to maturity is important in calculating the compound interest can earn.
- Difference between face value and price value – If the investor keeps a bond to maturity, he receives the bond’s face value at the end. The actual price he paid for the bond may be more or less than the face value of the bond.
Technically, the price of a bond is simply the sum of the present values of all its remaining cash flows. Here, the present value can be estimated by discounting each cash flows at the YTM. In other words, the YTM is the discount rate which equates the present value of the future cash flows of a bond to its current market price. In other words, it is the internal rate of return on the bond. The calculation of YTM involves a trial-and-error procedure. Software can be used to obtain a bond’s yield-to-maturity easily and accurately.