We first discussed the concept of yield in the preferred stock chapter. The idea is the same for bonds: yield measures the overall return of an investment. With bonds, several factors affect yield, including:
Interest rate (coupon)
Purchase price
Length of time until maturity
The interest rate of a bond and its yield can sound like the same thing, but they aren’t (except for nominal yield, discussed below). The interest rate (coupon) is the annual interest the issuer pays to the bondholder. Yield is the bond’s overall rate of return. The coupon is part of yield, but yield changes when the bond is purchased at a discount or a premium.
We’ll discuss the following yields in this chapter:
The nominal yield is another name for the bond’s interest rate (coupon). You’ll rarely calculate nominal yield, but you may be asked for the formula.
For example:
A $1,000 par, 4% bond
As you can see, the calculation simply confirms the 4% coupon that was already given. Nominal yield depends on two values that don’t change over the life of the bond:
This bond pays $40 per year regardless of what happens to its market price.
The nominal yield is fixed throughout the life of the bond. Unlike the other yields we’ll discuss, the bond’s market price is not part of the calculation. When you’re given bond information, the first percentage you typically see is the nominal yield (coupon).
Let’s add one detail to the example.
A $1,000 par, 4% bond bought for $800
If this bond is bought at $800 (discount), the bond’s overall return will be higher than its coupon. That’s because the investor has two sources of return:
Coupon
Discount
The investor receives 4% of par ($1,000) each year, and also benefits from the difference between the purchase price ($800) and the maturity value (par, $1,000). That extra $200 increases overall return, so the yield must be above 4%.
As in the preferred stock chapter, current yield is found by dividing annual income by the security’s current market price.
A $1,000 par, 4% bond bought for $800. What’s the current yield?
Can you figure it out?
The current yield is higher than the coupon, which matches the general rule: for discount bonds, current yield is higher than the coupon.
Current yield is important for the exam, but it has a major limitation: it doesn’t account for time.
Yield is an annualized measure of return. For a discount bond, a large part of the return comes from the discount ($200), but current yield doesn’t tell you how quickly that $200 is earned. A $200 discount earned over 1 year is very different from a $200 discount earned over 30 years.
Here’s a video breakdown of a practice question on current yield:
Now let’s see how current yield works for a premium bond.
A $1,000 par, 4% bond bought for $1,100
This investor still receives $40 per year in interest. However, because bonds mature at par, paying $1,100 for a bond that matures at $1,000 creates a $100 loss at maturity. That loss pulls the investor’s overall return below the coupon.
A $1,000 par, 4% bond bought for $1,100. What is the current yield?
Can you figure it out?
Here, the current yield is lower than the coupon, which matches the general rule: for premium bonds, current yield is lower than the coupon.
Current yield is an approximate measure that can appear on the Series 66 exam, but it’s not the most useful yield for real-world comparisons. The next two yields are more complete because they incorporate time.
Yield to maturity and yield to call formulas are difficult to memorize and typically are not heavily tested. Exam questions are more likely to focus on the relationships of the yields, which is best depicted on the bond see-saw (discussed at the end of this chapter). Additionally, it’s possible a test question focuses on the components of these yield formulas. Don’t spend a significant amount of time focusing on the math related to these yields.
Unlike current yield, yield to maturity (YTM) does factor in time. YTM assumes the investor buys the bond and holds it until maturity.
A 10-year, $1,000 par, 4% bond is trading at $800. What is the yield to maturity (YTM)?
This formula is easier to understand if you separate the pieces:
The result (6.7%) is higher than the coupon (4%). That fits the pattern: when a bond is purchased at a discount, the discount adds to return, so YTM is higher than the coupon.
Now compare that to a premium bond.
A 10-year, $1,000 par, 4% bond is trading at $1,100. What is the yield to maturity (YTM)?
Here’s what’s happening:
The result (2.9%) is lower than the coupon (4%). Again, the pattern holds: when a bond is purchased at a premium, the premium reduces return, so YTM is lower than the coupon.
Yield to call (YTC) applies only to callable bonds. If a bond isn’t callable, YTC doesn’t exist. YTC is the bond’s overall rate of return if it’s held until the call date (assuming it’s called as soon as it becomes eligible).
The YTC formula is similar to the YTM formula, but it uses the call date and call price instead of maturity and par. Calculating YTC is generally less important for the exam than calculating YTM.
A 10-year, $1,000 par, 4% bond is trading at $800. The bond is callable at par after 5 years. What is the yield to call (YTC)?
The YTC (8.9%) is higher than the coupon (4%), and it’s also higher than the YTM (6.7%). The reason is timing: the investor earns the $200 discount sooner.
Earning that price gain faster increases the annualized return.
Now look at a premium bond.
A 10-year, $1,000 par, 4% bond is trading at $1,100. The bond is callable at par after 5 years. What is the yield to call (YTC)?
The YTC (1.9%) is lower than the coupon (4%), and it’s also lower than the YTM (2.9%). Again, timing explains the difference.
Losing that premium sooner reduces the annualized return.
Sign up for free to take 12 quiz questions on this topic