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What is a Bond Yield?

definition

A bond’s current yield is the ratio of its periodic payment (coupon) divided by its current market value and expressed as a percentage.

🤔 Understanding bond yield

When you buy a bond, the amount of money in interest payable to you is a percentage of the bond's issue price. That amount of money never changes. When bonds are traded, their market value can change. When their market value changes, the amount of money payable to you now represents a different percentage of the market price. This is a bond's yield.

If you own 10 marbles out of a stash of 100 marbles, you could say you own 10%. But what if the stash of marbles increases to 200? Would you still own 10%? No. You would still own 10 marbles, but now you would own 5% of the stash. This is how bond yields work. When bond prices rise, bond yields drop, and vice versa.

example

Netflix has gone through several bond offerings over the years to raise billions of dollars to acquire media content and grow its company. On February 5, 2015, the company issued a total of $800 million worth of 10-year bonds called the NETFLIX 2025. These bonds have a face value of $100 and a coupon rate (interest payable) of 5.875% which is equal to about $5.88.

On October 15, 2019, the bond yield for NETFLIX 2025 was 3.31%. This means that the NETFLIX 2025 bond was trading for more than the face value of $100 on the bond market. Investors who wanted to buy this bond on October 15, 2019 would’ve had to pay about $111 instead of the face value (original price) of $100.

Takeaway

A bond yield is like comparing a pizza slice to the size of the whole pizza...

If a pizza slice from a small pizza is the same size as a pizza slice from a large pizza — that slice represents a different percentage of each pizza. The size of the pizza slice (coupon payment) stays the same, but the size of each pizza (market value) is different. When investors buy the pizza at market price, they are hungry to know what percentage of the pizza their slice represents (bond yield).

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Tell me more...

What is a bond yield?
What’s the difference between coupon rates and bond yields?
What causes bond yields to rise or fall?
Can you lose money investing in bonds?
What is a bond rating?

What is a bond yield?

Bonds are generally fixed income investment securities. This means that the issuer of a bond is contractually obligated to pay the bond holder at a fixed annual interest rate (coupon rate) on a bond’s original value (face value) at regular intervals (usually once or twice a year) until the bond matures.

Fun fact: The interest rate on bonds is also called the coupon rate because in the olden days investors who held a bond had a book of coupons. The coupons represented the interest payments due to them by the bond issuer. Investors had to clip a coupon out of their booklet and give it to the bond issuer to get their coupon payment.

Even though bonds are loans issued for a specific amount, they may trade for more (at a premium) or less (at a discount) than their original face value on the secondary market. But the dollar amount of the coupon payment (original interest payable) always stays the same.

Because a bond’s coupon payment doesn’t change but a bond’s market price may change, the coupon payment represents a different percentage of the bond’s market value when the bond’s market value increases or decreases. This percentage is a bond’s yield.

Let’s illustrate. Suppose you purchase a $5,000 bond from the federal government (Yes, governments need to borrow money, too) with a coupon rate of 4% and a maturity date of 10 years.

You expect to receive your coupon payment of $200 ($200 = 4/100 x $5000) per year for the life of the bond unless the government defaults. (Although the chances of that happening are relatively low.)

The easiest way to calculate a bond’s yield is to divide its coupon payment by its face value and then multiply by 100 to get a percentage. We can see that the bond yield right after you buy it is the same as its coupon rate.

Coupon Payment / Face value X 100 = Coupon Rate (Original Bond Yield)

$200/$5000 X 100 = 4%

But what if there is strong investor demand for that particular government bond and trading prices for that bond rise on the bond markets? Now, your $5000 bond is trading for, say, $5,500 on the market.

Let’s use the same equation to calculate the bond yield of the $5000 bond when it’s trading for $5500.

Coupon Payment / Current Market Value X 100 = Current Bond Yield

$200/$5500 X 100 = 3.64%

Did you notice the bond yield decreased when the market value of the bond increased? This is because the coupon payment of $200 is now a smaller percentage of the bond’s new market value of $5500.

It also works in the opposite direction.

What happens to the bond yield if your $5000 bond trades on the market for $4500?

Coupon Payment / Current Market Value X 100 = Current Bond Yield

$200/$4500 X 100 = 4.4%

Notice how the bond yield increased?

When bond market values rise, bond yields fall. When bond market values fall, bond yields rise.

Current bond yields help investors determine what bonds to buy in the bond market because it helps to show how price changes affect the bond’s original interest rate

What’s the difference between coupon rates and bond yields?

You can think of bonds as sort of having two interest rates at play.

  • The coupon rate (original fixed interest rate) issued on the face value (original loan value) of the bond — The dollar amount of the coupon payment will always be the same. An investor purchasing the bond will get that dollar amount irrespective of how much the bond is trading for on the market.
  • The bond yield which is the ratio of a bond’s periodic coupon payment (original fixed interest amount) divided by its current market value and expressed as a percentage — The bond yield shows investors what percentage they will make on their investment (return).

What causes bond yields to rise or fall?

There are several factors that can cause bond yields to rise or fall. Remember that a change in the bond yield is directly related to a change in the market value of a bond. If the market value changes, the bond yield will change. Some of the most common reasons that bond yields rise or fall are:

  • A company’s financial strength or weakness — The market value of corporate bonds may increase or decrease depending on a company’s financial health — or its industry — in addition to economic factors. If the market value of a bond rises, the bond yield will fall and visa versa.
  • Market sentiment — If something happens in politics, the economy, or on the world stage in general that spooks investors, bond yields can change. Investors who are usually into riskier investments such as stocks tend to flock to safer investments such as bonds when they are worried about the markets. This demand for bonds drives bond market values up and bond yields down. But when stocks are rising, investors may abandon bonds for stocks. Lack of demand can drive bond market values down and bond yields up.
  • Federal interest rates (interest rate risk) — Bond yields rise and fall when the Federal Reserve raises or cuts Federal interest rates. Government bonds are issued at current interest rates set by the Federal Reserve. When Federal interest rates change, newly issued government bond yields change. This also affects the market price of previously issued government bonds trading on the market. Here’s how:

The Federal Reserve may raise interest rates when the price of goods and services is too high (inflation) to try to get people to borrow and spend less which lowers prices. But if the Federal Reserve thinks economic growth is slowing down, it may cut interest rates to try to get people and businesses to borrow and spend more.

  • If the Federal Reserve raises interest rates — New government bonds will be issued with a higher coupon rate. Previously issued government bonds with lower coupon rates will no longer be worth as much on the market. Their market values decrease, which causes their bond yields to rise.
  • If the Federal Reserve cuts interest rates — New government bonds will be issued with a lower coupon rate. Previously issued government bonds with higher coupon rates will now be more attractive on the bond market. Their market values increase which causes their bond yields to fall.

In a nutshell, when Federal interest rates rise, bond yields rise. When Federal interest rates fall, bond yields fall.

Can you lose money investing in bonds?

Investing in bonds is not risk-free. You can lose money if:

  • You sell your bond on the market for less than you paid for it — However, if you hold the bond until it matures, you will likely get your initial investment back, in addition to the periodic coupon payment you are paid over the length of the bond.
  • The bond issuer ‘defaults’ and is unable to pay you back — Remember that bonds are loans. You only make money if the issuer pays you back. This is why paying attention to a bond's credit rating is important.

What is a bond rating?

Credit ratings for bond issuers are given by rating agencies such as Standard & Poor's, Moody's, and Fitch. These agencies rate the creditworthiness of governments (Yes, even countries have credit ratings), companies, and any institution that issues debt instruments.

Credit ratings indicate the likelihood of an institution to meet its financial obligations. While each of these three agencies may come up with their ratings a different way, they generally look at an institution’s level of debt, ability to pay its debt, and willingness to pay — based on its balance sheets, income statements, and other factors.

Credit ratings are assigned different codes by these three major rating agencies. The highest rating a bond issuer can receive is an ‘AAA’ from Standard & Poor's and Fitch, and an ‘Aaa’ from Moody’s. These ratings mean that a bond issuer is least likely to default.

Low ratings for bond issuers such as a ‘C’ from Standard & Poor's and Fitch, or a ‘Ca’ from Moody’s, shows that a bond issuer is likely to default and may not be able to pay its investors. Ratings lower than that show that a bond issuer is already defaulting.

While high credit ratings can signify a safer investment, some investors look at bonds with lower credit ratings because they know that higher risk means potentially higher bond yields. Lower rated bonds are sometimes called junk bonds or “high yield bonds.” 20200103-1048520-3152703

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