What is a Bond Yield?
A bond yield is the return that an investor expects when buying a bond. A commonly used term is “yield to maturity” (YTM). The YTM is expressed as a figure which takes into account the price paid for the bond, its coupon (the fixed amount of interest it pays) and when the investor will receive his initial lump payment back (when the bond ‘matures’).
What is critical to understanding bonds yields is the relationship they have with bond prices.
The yield of a bond is the return the investor makes on the money he has invested, in the context of how much the market values the bond.
How to calculate a bond yield
A crude way of calculating this is simply:
Coupon/market price x 100
Say I issue a bond, before my creditworthiness comes into doubt. The market will no longer be sure that I will be able to repay my debt. The price of my debt is now worth less, and the market demands a higher return on investment to take on the additional risk. The market price falls, but the coupon still remains the same.
The opposite can happen also. Say the market suddenly finds me more creditworthy, the value of my debt will increase and the yield of my bond will decrease.
The main lesson is that yields are inversely linked to price. If the market price of a bond increases, then the yield decreases. If the market price of a bond decreases, its yield increases.
Markets will demand certain yields – depending on the creditworthiness of the debtor, and the macro environment. The ‘risk free’ yields of high quality gilts and the central bank base rates generally set the tone for the rest of the market. Ratings agencies grade these bonds for creditworthiness with grades from AAA to ’junk’.
Emerging market bonds have far higher yields than developed countries, and economically distressed countries like Greece have very high yielding bonds in a similar way – the market demands that they receive proportional returns for the risk they are taking. Certain hedge funds specialise in finding junk bonds they believe aren’t as risky as the market prices, and make huge returns when this pays off.
Related Articles:
Category: Financial Glossary