Many new investors are surprised to learn that a bond's price and yield, just like that of any other publicly-traded security, change on a daily basis. Strange for an investment with a fixed face value, interest rate and maturity, isn't it? That's because bonds can be sold before maturity in the open market, where the price can fluctuate.
Measuring return with yield
Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated by the following formula:
yield = coupon amount/price. When the price changes, so does the yield.
Here's an example: Let's say you buy a bond at its $1,000par value with a 10%coupon.
If you hold on to it, it's simple. The issuer pays you $100a year for 10years, and then pays you back the $1,000 on the scheduled date. The yield is therefore 10% ($100/$1000).
If, however, you decide to sell it on the market, you won't get $1,000. Why? Because bond prices change on a daily basis of prevailing interest rates.
If the price of the bond in the market is $800, it's selling under face value or at a discount. If the price of the bond in the market is $1,200, it's selling above face value, or at a premium.
Regardless of the market price of a bond, the coupon remains the same. In our example, the bond holder continues to receive $100a year.
What changes is the bond yield. If you sell it for $800, the yield will be 12.5% ($100/$800). If you sell it for $1,200, the yield will be 8.33% ($100/$1,200).
Yield to maturity
Of course, in real life, things tend to be more complicated. When bond investors refer to yield, they're usually referring to yield to maturity (YTM). YTM is the sum of:
- all the interest payments you'll receive (and assumes that you'll reinvest the interest payment at the same rate as the current yield on the bond)
- any gain (if you purchased at a discount) or loss (if you purchased at a premium)
YTM is a yield calculation that enables you to compare bonds with different maturities and coupons.
The link between price and yield
The yield's relationship with price can be summarized as follows: When price goes up, yield goes down and vice versa. Technically you'd say the bond's prices and its yield are inversely related.
Here's a main point of confusion. How can high yields and high prices both be good when they can't happen at the same time?
The answer depends on your point of view. If you're a bond buyer, you want high yields. A buyer wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future.
The influence of interest rates
The face value, coupon, maturity, the issuer and yield are all factors that play a role in a bond's price.
However, the factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall , thereby raising the yield of the older bonds and bringing them into line with the newer bonds being issued with a higher coupon.
And, when interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with the newer bonds being issued with a lower coupon.
Tools and tips
Characteristics of bonds
Learn about face value, coupons and default risk.
Read tip- Characteristics of bonds
Types of bonds
Discover the 3 main categories of bonds.
Read tip- Types of bonds
How to read a bond table
What the columns in a bond table stand for.
Read tip- How to read a bond table
