Understanding Bond Yields

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Comparing a bond's yield to other investment options only requires four pieces of information: the bond's par value, its market price, its maturity date, and the bond's coupon rate. That's all the information needed to calculate the return from a bond. But as we'll discuss later on, really understanding bond yields is more complex than just calculating a yield to maturity.

Bond Terminology

We've already used several bond terms that need some additional explanation. If you want to understand what you're buying when you invest in a bond, then you need to know some of the basic terms you'll be encountering.

Bond Par Value

Additional Resources

A bond's par value is the maturity value of the bond. It is an amount that investors will receive if they hold a bond to maturity. A bond's par value is also referred to as the maturity value, face value, and principal amount.

Most companies issue bonds with a par value of $1,000. Government bonds, such as Treasury bonds, are often issued with par values in excess of $1,000.

Bond Market Price

The market price of a bond is the current value the market places on a particular debt issue. The market price of a bond is a function of interest rates, the issuer's financial condition, and buyers' interest.

When a bond sells for less than its par value, it is said to be selling at a discount. When a bond sells for more than its par value, it is said to be selling at a premium.

Maturity Date

The maturity date of a bond is the date on which the issuing company would pay the holder of the bond its par value. Once paid, the company issuing this debt is no longer obligated to make interest payments on the bond, and the debt is said to be retired.

There are certain bond features that allow the issuing company to retire a bond before its maturity date. These are called callable bonds. Maturity dates can be as long as 30 years into the future.

Bond Coupon Rates

A bond's coupon rate is the interest rate that is written into the terms of the bond indenture, and this value often appears on the bond certificate itself. The bond coupon rate is also referred to as the stated rate or the nominal rate of interest.

Bond Rate Example

The bond coupon rate is the interest rate the bondholder will receive, and this rate is expressed as a percentage of the bond's par value. For example, a bond with a par value of $1,000, and a coupon rate of 9.0%, entitles the holder of the bond to payments of $90 per year until the maturity date.

Current Bond Yield

A bond's current yield is a function of the bond's current market price and the bond's coupon rate. The current yield on a bond with a market price of $900, a par value of $1,000, and a coupon rate of 9.0%, would be $90 / $900 or 10.0%.

Bond Yield to Maturity

A bond's yield to maturity is a measure that allows investors to account for all of the possible returns they will receive from the bond. This includes interest payments received, the possibility of reinvesting those interest payments, and the difference between the price paid for a bond (or market price) and the bond's par value at maturity.

Calculating Bond Yields

Bond yields are constantly changing due to the ever shifting market conditions and financial condition of the issuing company. Because of these changes, bonds rarely sell for par value. Bonds require the approval of the Securities and Exchange Commission and underwriting of the bond must also be arranged.

This process takes time, and during that time market conditions as well as the financial condition of the company can also change. These changes can affect the company's bond ratings, which affects the bond's yield.

If you understand why a bond's market value is almost never at par value, then you'll also understand why the bond's coupon value is almost never the same as the current bond yield or yield to maturity. Bonds almost always sell at a premium or discount to their par value.

This simple market fact brings us to three rules of thumb that help us to understand the relationship between coupon rate, current yield, and yield to maturity or YTM.

If a bond sells at a premium to par value, then: Coupon Rate > Current Yield > YTM.
If a bond is selling at a discount to par value, then: Coupon Rate < Current Yield < YTM.
If a bond happens to be selling at par value, then Coupon Rate = Current Yield = YTM.

Bond Yield Calculator

Our bond yield calculator can help you to quickly figure out all of these different bond yields. This includes both the yield to maturity and current yield values.

To run our calculator, all that is required are four readily-available pieces of information for the bond:

Current Bond Price
Par Value
Coupon Rate, and
Years Until Maturity

If you find a bond that you're interested in buying, then you can take that bond quote and use our bond calculator to help you figure out the return you can expect to receive from this investment.

Buying Bonds

Investors buy bonds because they are considered relatively safe investments. Unfortunately, understanding bond yields and interpreting those values takes more work than simply examining the percentages a calculator provides.

All bonds carry a risk of default, or non-payment, of principal and interest. No matter how small it might be, even government issued bonds carry a risk of default. That's why investors have come to depend on bond ratings to help them understand this risk.

Bond ratings are issued by third parties such as Standard and Poor's, Moody's and Fitch Ratings. These rating agencies use an alphanumeric system that qualifies credit risk from investment grades through default. We've discussed this entire rating system in our publication on Bond Ratings.

As a potential buyer of bonds, you need to understand the risk of default, especially if you're looking at high yield bonds that would be considered "junk" bonds.

Interest Rate Risk and Bond Value

If you don't plan to hold a bond until its maturity date, then there is a second risk you need to be aware of: interest rate risk. In this example, we're going to hold everything constant (market factors, financial condition) except for interest rates.

If you buy a bond and interest rates are rising, then the market price of the bond will fall. That's because the market will demand a higher rate of interest from the bond, and for that to occur, the price of the bond must fall.

We can illustrate the above concept using the example below.

Bond Value Example

Let's say you buy a bond for $900 with a par value of $1,000. If the coupon rate is 9.0%, then your current yield is $90 / $900 or 10.0%. If interest rates rise, and the market demands 11.0% from that same bond, then the price of the bond must fall to $90 / 0.11 or $818.18.

As a bondholder, you're still receiving $90 per month, but the market price of the bond just dropped from $900 to $818.18, or $81.82. Conversely, if you buy a bond and interest rates decline, then the market price of the bond will rise.

This drop, or rise, in the bond price is meaningless if you intend to hold the bond until maturity.

Buying Bonds Through a Broker

By far the most common way to buy bonds is through a broker and /or via a brokerage account. You have the same choices you'd have with stocks, including a full service broker or a discount (less expensive) broker. When you buy a bond, you will pay a sales commission. The fee structure works the same way it would when you're buying a stock. It pays to shop around and compare fees.

Bonds can be purchased through a direct offering of newly issued securities or in the secondary market. An investor's purchase options are pretty much unlimited when it comes to bonds. They'll be able to find everything from the highest rated 30 year Treasury bonds to junk bonds from companies about to declare bankruptcy.

With bonds, you usually get what you pay for. Keep that fact in mind when you're wondering if buying a junk bond is a good idea because of the relatively high rate of interest they're paying.

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