Trading in the Fixed Income Market - Understanding Bond Yields and Interest

In Part 1 of Trading in the Fixed Income Market we discussed the market valuation of bonds. However, the first thing that investors usually want to know when considering buying a bond is actually the amount of return that can be expected. In other words, “What does the bond yield?” Unfortunately, this isn’t quite as simple a question to answer as it may first seem, because a bond has a minimum of two yields: its current yield and its yield to maturity (YTM). In order to illustrate these two yields, let’s examine an 8% $1,000 bond with a time to maturity of 10 years.

The bond’s current yield is calculated by dividing the annual interest that the bond pays by the bond’s current price. (Interest: 8% annually of $1,000 = $80.) If, for example, the bond was currently selling for either a discount of 91 or a premium of 114 (91 points x $10 and 114 points x $10; which would be $910 and $1,140; respectively) the current yield would be respectively:

Unfortunately, a bond’s current yield doesn’t take into account the fact that when the bond matures it will return its face value (in our example above, $1,000) to its investor, regardless of the price that the investor paid for it. If the bond was purchased for $910 and held until its maturity, the investor would not only earn $80 per year in interest, but would also receive a gain of $90 over the ten-year holding period ($1,000 received at maturity minus the $910 purchase cost). Likewise, if purchased for $1,140, the investor would lose $140 over the ten-year period.

The yield measure which takes into account the effect of gain or loss over the investment period until bond maturity as well as the interest the investor receives along the way is known as the yield to maturity. Intuitively, a bond purchased at a discount to its par, or face, value will have a YTM which is higher than its current yield. A bond bought at a premium to its par value will have a YTM that’s lower than its coupon yield. Taking again our bond from the example above the YTM would be:

9.41% if the bond was purchased for $910
6.11% if it were purchased for $1,140