|Lots of different definitions of
'yield- it's easy to get confused. Here's the textbook
A bond with a face value of £100 may pay interest of £4
every year. £4 as a percentage of £100
is 4%, and this is described as a 'yield'.
This particular yield might
be described as a 'face value yield', but it isn't. Traditionally
it has the much shorter name of 'coupon'.
There are other types of yield.
'Current yield' is....
When this same bond is traded in the market,
it will change hands at a price agreed between buyer and seller.
This reflects prevailing interest rates and perceptions of the bond's
Let's say this price is £80.
The fixed annual interest of £4 now represents 5% of the bond's
market price of £80. This 5% is the 'current yield' or 'current
annual yield' or 'running yield' or 'income yield'.
'Yield to Redemption'
Most bonds have a redemption date - a date at which the full face
value will be paid to the owner (unless the owner defaults). The
bond is said to 'mature' on that date.
Suppose, in the previous example,
that the bond has 10 years to redemption. A buyer at £80 will
then get £4 of interest per year for 10 years and £100
at the end of year 10. The £100 represents a premium of £20
over cost, or £2 per year spread over 10 years. When added
to the coupon this gives an annual gain of £6. £6 as
a percentage of £80 is 7.5% and is an approximation of the
'yield to redemption' (YTR).
In reality the YTR is calculated in a more sophisticated
way to take account of the time value of money (or compounding).
The true YTR in the above example is 6.8%.
The YTR is the only really meaningful yield
measure for term bonds. We can expect all bonds with comparable
terms and risks to have similar YTRs at any one time. Look
at actual bond yield and price quotations at Bondscape (sidebar)
and see how the YTRs cluster together. Whereas the income yields
are all over the place.
An irredeemable bond has, by definition, no
redemption promise and therefore the YTR and the running yield are
When interest rates change, so do capital values
The mathematics of yields determines how bond values fluctuate,
and explains the capital risk inherent in a bond.
Back to our familiar 4% coupon
bond. Let's say it's irredeemable. When issued at par (ie the buyer
paid face value) the market rate of interest for this type of bond
would have been 4%. If interest rates then move up (in reponse to
changing economic conditions) to 5%, the current yield on this bond
will also move to 5%. That means the price will go to 80 (the £4
coupon is 5% of 80)- a 20% loss. That's one reason why bonds are
riskier than they look.
Long-term bonds are less risky than irredeemable
bonds, and short-term bonds are less risky than long-term bonds.
Play with the maths and see.