Bond Yield and Types
What is yield?
Bond yield refers to the rate of return an investor can expect to receive from a bond. It is a crucial metric for assessing the profitability of a fixed-income investment. The yield of a bond can be calculated in different ways, each providing a unique investment perspective.
Let us now discuss about types of bond yield more in detail.
a). Coupon yield: This is also referred to as bond’s coupon rate or Nominal yield. The annual coupon payment is divided by the bond’s current market price.
Coupon yield = (Annual Coupon Payment/Face Value)*100
b). Current yield: The current yield of a bond provides investors with a quick snapshot of the annual income generated by the bond in relation to its current market price. It is a simple yield calculation that does not take into account the potential capital gain or loss if the bond is bought or sold at a price different from its face value.
Current yield = (Annual Coupon Payment / Current Market Price)*100
c). Yield to Maturity: YTM represents the total return an investor can expect if the bond is held until maturity (Interest income + Capital gain or loss). Discount rate that equates the present value of all future cash flows (coupon payments and the principal repayment at maturity) to the current market price of the bond.
YTM = {(c + (FV-PV)/t)} / {(FV+PV)/2}
where,
- C — Interest/coupon payment
- FV — Face value of the security
- PV — Present value/price of the security
- t — How many years it takes the security to reach maturity
d). Yield to call: This is similar to YTM but here, it is assumed that the bonds will be called by the issuer before the maturity date. This applies only to bonds that have a call provision, where the issuer can redeem the bonds before they reach maturity. The bond value here is roughly equal to the present value of future earnings or cash flows.
Initial Bond Price (PV) = C × [1 — {1 / (1 + r) ^ n} / r] + Call Price / (1 + r) ^ n
Where:
- C = Coupon
- r = Yield to Call
- n = Number of Periods Until Call Date
Let us now understand this with an example.
For example, let’s assume a bond becomes callable in 1 year (i.e. “NC/1”) with the following characteristics:
- Par Value (FV) = 100
- Coupon Rate = 8%
- Call Price = 104
- Number of Periods (n) = 1
- Present value of the bond = 105
The Coupon of the bond would be = 100 × 8% = 8
If we enter these assumptions into our formula, the initial bond price (PV) comes out to 105.
- 105 = 8 × {1 — [1 / (1 + YTC) ^ 1] / YTC} + 104 / (1 + YTC) ^ 1
- Yield to call = 6.7%.
e). Yield to worst: This takes into account the lowest potential yield, considering various scenarios such as bond call, maturity, prepayments, and other features that may impact the return.
The yield to worst (YTW) on a callable bond is the lower return between the yield to maturity (YTM) and the yield to call (YTC).
f). Realized Yield: The actual yield earned by an investor, taking into account any capital gains or losses if the bond is sold before maturity. It may include dividends, interest payments, and other cash distributions. The realized yield on bonds is the sum of coupon payments received throughout the holding period, along with the net change in the value of the initial investment, calculated on an annual basis.
Realized yield = {(Dividend + closing market price of share)/(opening market price of share)}
