Types of Bonds
Yield is a critical concept in bond investing because it is the tool you use to measure the return of one bond against another.
In essence, yield is the rate of return on your bond investment. However, it is not fixed, like a bond’s stated interest rate. It changes to reflect the price movements in a bond caused by fluctuating interest rates.
Here is an example of how yield works: You buy a bond, hold it for a year while interest rates are rising and then sell it. You receive a lower price for the bond than you paid for it because, as indicated in “Understanding Interest-Rate Risk,” no one would otherwise accept your bond’s now lower-than-market interest rate. Although the buyer will receive the same amount of interest you did and will have the same amount of principal returned at maturity, the buyer’s yield, or rate of return, will be higher than yours was—because the buyer paid less for the bond.
There are numerous ways of measuring yield, but two—current yield and yield to maturity—are of greatest importance to most investors.
The current yield is the annual return on the amount paid for a bond, regardless of its maturity. If you buy a bond at par, the current yield equals its stated interest rate. Thus, the current yield on a par-value bond paying 6% is 6%.
However, if the market price of the bond is more or less than par, the current yield will be different. For example, if you buy a global 1,000 bond with a 6% stated interest rate after prevailing interest rates have risen above that level, you would pay less than par. Assume your price is €900. The current yield would be 6.67% (€1,000 x .06/€ 900).
A more meaningful figure is the yield to maturity, because it tells you the total return you will receive if you hold a bond until maturity. It also enables you to compare bonds with different maturities and coupons. Yield to maturity includes all your interest plus any capital gain you will realise (if you purchase the bond below par) or minus any capital loss you will suffer (if you purchase the bond above par).
Ask your financial advisor to provide you with the precise yield to maturity of any bond you are considering. Do not buy on the basis of the current yield alone, because it may not represent the bond’s real value to you.
The yield to call tells you the total return you will receive if you were to buy and hold the security until the call date. As an investor, you should be aware that this yield is valid only if the bond is called prior to maturity. The calculation of yield to call is based on the coupon rate, the length of time to the call date, and the market price of the bond.