What It Measures
Why It Is Important
Bonds can tie up investors’ money for periods of up to 30 years, so knowing their yield is a critical investment consideration. Similarly, bond issuers need to know the price they will pay to incur their debt, so that they can compare it with the cost of other means of raising capital.
How It Works in Practice
Bonds are issued in increments of $1,000. To calculate the yield amount, multiply the face value of the bond by the stated rate, expressed as a decimal. For example, buying a new 10-year $1,000 bond that pays 6% interest will produce an annual yield amount of $60:
1,000 × 0.06 = $60
The $60 will be paid as $30 every six months. At the end of 10 years, the purchaser will have earned $600, and will also be repaid the original $1,000. Because the bond was purchased when it was first issued, the 6% is also called the “yield to maturity.”
This basic formula is complicated by other factors. First is the “time-value of money” theory: money paid in the future is worth less than money paid today. A more detailed computation of total bond yield requires the calculation of the present value of the interest earned each year. Second, changing interest rates have a marked impact on bond trading and, ultimately, on yield. Changes in interest rates cannot affect the interest paid by bonds already issued, but they do affect the prices of new bonds.
Tricks of the Trade
Yield to call. Bond issuers reserve the right to “call,” or redeem, the bond before the maturity date, at certain times and at a certain price. Issuers often do this if interest rates fall and they can issue new bonds at a lower rate. Bond buyers should obtain the yield-to-call rate, which may, in fact, be a more realistic indicator of the return expected.
Different types of bond. Some bonds are backed by assets, while others are issued on the strength of the issue’s good standing. Investors should know the difference.
Zero-coupon bonds. These pay no interest at all, but are sold at a deep discount and increase in value until maturity. A buyer might pay $3,000 for a 25-year zero bond with a face value of $10,000. This bond will simply accrue value each year, and at maturity will be worth $10,000, thus earning $7,000. These are high-risk investments, however, especially if they must be sold on the open market amid rising interest rates.