Bond yield definition
Bond yield meaning
Bond yield helps investors to calculate the returns that they will make on their investment.
This is not to be confused with the coupon rate, which states the annual amount of interest that will be paid to the owner of a bond.
How bond yields work
Most bonds have a face value of $1,000, but their prices can go up and down on the secondary market. Bond prices and bond yields have an inverse correlation – meaning that as one goes up, one goes down.
Let’s imagine that Robert purchased a $1,000 bond with a coupon rate of 10%. It is due to mature in 30 years’ time and will pay a fixed amount of $100 in interest every year.
Ten years later, and newer bonds are coming with a coupon rate of 20%. This makes Robert’s current bond unattractive, because it pays less interest. As a result, a buyer may only be prepared to pay $500 for his bond. As they would continue to receive $100 interest annually, this would amount to a 20% yield on their investment and equalize the rates.
Alternatively, let’s imagine that newer bonds have a coupon rate of 5% instead – making Robert’s older bond a more attractive investment because it has a coupon rate of 10%. Now, he would be able to sell his financial instrument at a premium of $2,000. By dividing the annual coupon payment of $100 against the newly inflated bond price, we can see that it has a current yield of 5%.
Do yields matter?
That depends on an investor’s perspective and long-term goals. If they were planning to hold on to their bond until maturity – irrespective of changing economic conditions – the only measurement of return that will matter to them is the coupon rate.