A bond’s yield is its expected earnings over a specific period of time, usually expressed as a percentage.
In the case of calculating a bond’s return…
When an investor buys a bond, they are lending money to the bond issuer and receiving interest in return. Bondholders can use bond yield as a way of calculating their investment return. There are several different types of bond yields, each of which is calculated in a different way.
You can find the current yield by dividing its annual interest payments by the purchase price. In many cases, the purchase price may be the same as the bond’s face value, meaning the price at which it was issued and the amount the bond issuer will repay the investor at maturity.
For a bond purchased at its face value and held to maturity, the current yield is the same as its coupon rate.
Suppose a company released $100,000 of bonds, each with a face value of $1,000 and an annual coupon rate of 5%. At that coupon rate, the bond issuer will pay an annual interest of $50 for each bond.
Let’s imagine that due to market factors, an investor is able to purchase the bond for a discounted rate of $975. To calculate the current yield on the bond, the investor would divide the $50 interest payment by the bond’s $975 face value.
The bond’s current yield is 5.13%, which is higher than its coupon rate because of the discounted purchase price.
What’s important here?
It’s important for investors to understand bond yield because it represents their investment return. However, there’s no one right way to calculate yield.
A bond’s current yield can help an investor determine their return for a single year. However, they may also want to calculate their yield to maturity — meaning the bond’s expected return if they hold it until its maturity date — or the yield to call — meaning a callable bond’s expected return if the bond issuer redeems it at the first date they’re able to.
No matter what calculation you choose to use, you’ll find that the lower the price you purchase a bond for, the higher your yield compared to its coupon rate, and vice versa.