A bond yield is an annual amount you receive in interest from a bond, as a percentage of the bond’s initial cost. It is the premium that investors are paid for holding on to government or corporate debt.
It is used to compare the potential returns of all kinds of bonds.
Basically, a bond is a loan and they function pretty much in the same way a local bank charges borrowers for interest on the loans it gives out.
Traders pay attention to bond yields because they reflect investor confidence.
If there is a weak demand for a bond, its yields rise to attract more buyers.
On the other hand, lower bond yields typically imply that there is a high demand from investors, either because they are confident that they will get paid back at maturity or that they feel it is a safe place to hold their assets.
The interest rate the bond issuer will pay is called the coupon and it is fixed, but the yield varies because the formula depends on the price of the bond in the market.
For example, if you pay $100 for a bond with an interest rate of 5%, the yield you receive will be 5%.
But if you bought that same bond for $88, the yield would be about 5.7%. This figure is known as the current yield.
It’s based on market price and is the one most commonly used by investors to compare bonds.
There are other types of bond yield to look at.
- Nominal yield, which is the interest paid out divided by the bond’s face (original) value.
- Yield to maturity, which shows the average yield you can expect bond if you hold it until it reaches the end of its term.
More complex calculations of a bond’s yield will account for the time value of money and compounding interest payments. These calculations include yield to maturity (YTM), bond equivalent yield (BEY), and effective annual yield (EAY).