In layman terms, bonds are investments with fixed rate of return, unlike equity shares. This explains why bonds are often referred to as ‘fixed-income securities.’ The return on investment, in this parlance, is known as ‘yield.’ In the real terms, though the token rate of interest payable on bonds is fixed, the yield tends to change with a number of factors, such as change in prevailing interest rates in the economy and inflation. Let us look at what are the three types of bond yields and what they signify.
- Nominal Yield
Also known as the ‘coupon rate,’ it is the indicated rate of interest on the bond. The annual interest is calculated on the par value of the bond at the coupon rate. It is immaterial whether you purchased the bond at premium (more than par value) or at a discount (less than par value) – the nominal yield always concerns with the par value. For instance, 7% $250 Notes imply that 7% coupon rate is payable on $250, even if you bought the Notes at, say, $280.
- Current Yield
Current yield is the current percentage return on the security. It assumes the holder will keep the security only over the next one year and during that period there will be no change in its market price. In effect, it does not refer to the ‘total yield’ up to the time of maturity. It also eliminates the assumption of reinvesting the periodic receipts at a constant rate. It can be represented in the form of a form of a formula, as below:
Current Yield = Nominal Yield/Market Price
This percentage indicates the actual return if you decide to purchase the bond at current market price.
Yield-to-Maturity refers to the total return over the life of the security. Theoretically, it implies reinvestment of the annual interest receipts at a constant rate. It is considered the most important parameter to assess the viability of a bond investment. However, the calculation for YTM is rather complex that relies on a ‘trial and error method’ or the aid of some calculating device. The concept can be expressed mathematically, as:
N (1+R)-1 + N (1+R)-2 +… N (1+R)-n + P (1+R)-n = M
C H Annual Coupon Interest or Nominal Yield;
R H Yield-to-Maturity;
P H Par Value or Redemption Value;
n H Years left for maturity;
M H Price of the bond;
It is interesting to note that if and only if a bond is selling at par, the three yields are equal.