Trading in the Fixed Income Market - Understanding Bond Yields and Interest

Part 2: Understanding Bond Yields and Interest

In Part 1 of Trading in the Fixed Income Market we discussed the market valuation of bonds. However, the first thing that investors usually want to know when considering buying a bond is actually the amount of return that can be expected. In other words, “What does the bond yield?” Unfortunately, this isn’t quite as simple a question to answer as it may first seem, because a bond has a minimum of two yields: its current yield and its yield to maturity (YTM). In order to illustrate these two yields, let’s examine an 8% $1,000 bond with a time to maturity of 10 years.

The bond’s current yield is calculated by dividing the annual interest that the bond pays by the bond’s current price. (Interest: 8% annually of $1,000 = $80.) If, for example, the bond was currently selling for either a discount of 91 or a premium of 114 (91 points x $10 and 114 points x $10; which would be $910 and $1,140; respectively) the current yield would be respectively:

$80 / $910 = .0879 = 8.79%
$80 / $1,140 = .0702 = 7.02%

Unfortunately, a bond’s current yield doesn’t take into account the fact that when the bond matures it will return its face value (in our example above, $1,000) to its investor, regardless of the price that the investor paid for it. If the bond was purchased for $910 and held until its maturity, the investor would not only earn $80 per year in interest, but would also receive a gain of $90 over the ten-year holding period ($1,000 received at maturity minus the $910 purchase cost). Likewise, if purchased for $1,140, the investor would lose $140 over the ten-year period.

The yield measure which takes into account the effect of gain or loss over the investment period until bond maturity as well as the interest the investor receives along the way is known as the yield to maturity. Intuitively, a bond purchased at a discount to its par, or face, value will have a YTM which is higher than its current yield. A bond bought at a premium to its par value will have a YTM that’s lower than its coupon yield. Taking again our bond from the example above the YTM would be:

9.41% if the bond was purchased for $910
6.11% if it were purchased for $1,140

Investors normally make decisions about which bonds to invest in based on their YTMs. Because the YTM is a complex calculation which involves trail and error, it’s usually accomplished with the help of a programmable business calculator.

Bonds pay interest in arrears; in other words, they pay interest only after it’s earned. If our $1,000 bond pays interest in March and September, the March interest payment would compensate the investor for lending the issuer money from the previous September until March. The September interest payment compensates the investor for the loan of the money from the previous March until September.

Even though bonds pay interest only in arrears, the investors who own bonds earn interest for each day that they own them. When bonds are traded, the seller of the bond is entitled to receive any interest which has been earned but hasn’t yet been received. Going back to our bond which pays in March and September, if the owner sold this bond in June, he or she would be entitled to receive the interest earned from March (when the last interest payment was made) until the day that the bond was sold. This interest -- which has been earned to date but not yet received -- is known as accrued interest.

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