Bond yield is a measure of the return on investment for bonds, and there several kinds of yield that can be computed.
Yield on a bond is the amount of interest that it pays annually, as a percentage of the amount invested — at least, this is the most common type of yield discussed, which is known as Current Yield. If a bond pays quarterly or monthly income to the investor, these payments are totaled up and divided by the amount invested.
The amount paid for the bond contract may depend on the number of years left on the bond, since they have specific durations, and computations to that effect will illustrate what’s called the yield to maturity. In bond funds, the 30 day SEC yield and the company’s own calculation for the distribution yield can be compared to each other and to other bond funds.
There is also nominal yield, which is the coupon rate stated on the bond, and is a percentage of par value. If the interest rate environment changes, which is often, it will affect the price of bonds in the secondary market (between individuals on exchanges) and the required yield of new issues.
Required yield is the amount of interest investors expect for the amount of risk present in the bond investment, which is largely determined by the ratings the bond issue receives from third party ratings institutions such as Moody’s, Fitch, and S&P. Higher prices for bonds mean that bonds are in high demand, perhaps due to high volatility in the stock market.
Because demand is high, issuers of bonds can pay lower coupon rates, that is, they have a lower required yield, in order to raise the same amount of capital from investors. So there is an inverse relationship between price and yield.
Even on existing bonds trading in the secondary market, the higher price investors are willing to pay for the relatively high coupon rate means that the current yield the new owner of the bond gets for his money is actually lower than the current yield the previous owner received.
As interest rates increase, the spread between the risk-free rate and the yield on bonds in the market narrows, and so the prices of bonds will go down, since there is less intrinsic value.
What is Yield to Maturity?
What is the “Riskless” (or Risk-Free) Rate of Return?
What does Market Risk Premium mean?
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