What is a Bond Yield?

What is a bond yield? In simple terms, it's the return you earn on a bond investment, usually expressed as a percentage. Investors rely on bond yields to evaluate the profitability of a bond compared to other investment options. Whether you're considering government securities or corporate bonds, yield plays a crucial role in decision-making. Understanding this concept enables you to make more informed and smarter financial decisions when investing in fixed-income assets.

Bond yield meaning

The bond yield's meaning lies in understanding how much income a bond generates from its market value. It acts as a crucial metric to gauge the profitability of a bond investment.

• Current yield reflects the annual income a bondholder receives compared to the bond’s current market price. It helps evaluate short-term income potential.
• Yield to maturity (YTM) is the interest rate at which the total present value of a bond’s future cash flows, including periodic coupon payments and the amount received at maturity, equals its current market price. It represents the bond’s total expected return if held until maturity, assuming all payments are made as scheduled. YTM takes into account the time value of money and provides a comprehensive method for comparing bonds with different prices, maturities, and coupon structures.

Bond price yield: Formula and calculation

The bond yield is directly affected by the bond’s price, following an inverse relationship: when bond prices decrease, yields rise, and vice versa.

Current yield formula:

Current yield = (Annual coupon payment / Current market price of bond) × 100

Example:

Example: Let’s say you purchase a bond for ₹950, with a face value of ₹1,000 and an annual interest of ₹80.

Current Yield = (₹80 / ₹950) × 100 = 8.42%

YTM formula:

Price= ∑ₜ₌₁ᵀ [ Cash Flowₜ / (1 + YTM)ᵗ ]

Where:

• Price is the current market price of the bond
• Cash Flowₜ includes periodic coupon payments and final principal repayment
• T is the total number of periods until maturity
• YTM is the rate that equates all discounted future cash flows to the bond’s current price

Example:

Let’s say a bond has:

• Let’s say a bond has:
• Annual Coupon: Rs 80
• Time to Maturity: 15 years
• Current Market Price: Rs 950

To find the YTM, you’d solve for the rate at which the present value of all cash flows (annual coupon payments of Rs 80 + final Rs 1,000 principal repayment) equals Rs 950. That rate comes out to approximately 8.60%.

Even small fluctuations in market prices can have a significant impact on the yield. Additionally, accrued interest and market demand can affect both price and returns. This makes timing, credit quality, and market conditions crucial when investing in bonds.

Difference between bond yield vs bond price

Bond yield and bond price share an inverse relationship; when one rises, the other typically falls. Understanding this dynamic is crucial for making informed investment decisions.

• Definition:
  • The bond yield refers to the return earned from a bond, expressed as a percentage.
  • The bond price is the amount you pay to purchase a bond in the current market.
• Impact of market interest rates:
  • When interest rates rise, newly issued bonds offer better returns, causing existing bond prices to fall and yields to increase.
  • When interest rates fall, existing bonds with higher coupon rates become more attractive, resulting in higher prices and lower yields.
• Investor focus:
  • Yield-focused investors prioritise regular income.
  • Price-focused investors may aim for capital appreciation.
• Volatility & stability:
  • Bond prices can fluctuate in response to changes in market sentiment, inflation expectations, and the economic outlook.
  • Yields offer a more consistent view of expected returns.
• Other influences:
  • Longer-maturity bonds react more to interest rate changes.
  • Changes in credit ratings affect bond prices and perceived risk.

Different types of bond yields

• Effective annual yield (EAY): EAY accounts for the effect of compounding in a year. It is beneficial when bond interest is paid more frequently than once a year. EAY provides a more accurate measure of annual return than simple yield figures.
• Yield to call (YTC): Relevant for callable bonds, which issuers can redeem before maturity. YTC helps assess potential returns if the bond is called early, often in a falling interest rate environment.
• Nominal yield: The fixed coupon rate stated on the bond. It doesn’t reflect market price or current income, but it provides a base reference.
• Yield spread: Represents the difference in yield between two bonds, such as corporate and government bonds. It indicates the relative risk or opportunity associated with different issuers.
• Realised yield: Calculates the return based on the actual sale price before maturity. Useful for investors who don’t hold bonds till the end.
• Tax-equivalent yield (TEY): This is particularly useful when comparing tax-free bonds, such as municipal bonds, to taxable bonds. It adjusts the yield of a tax-free bond to reflect what a taxable bond would need to offer to match it post-tax. This is crucial for investors in higher tax brackets.
• Adjusted yield / risk-adjusted yield: These measures refer to the yield in the context of the risk taken. Two bonds may offer the same yield, but if one is significantly riskier (e.g., has a lower credit rating), its attractiveness decreases when adjusted for that risk.
• Inflation-adjusted yield: This is the yield after accounting for inflation. For long-term investors, the actual yield provides a clearer picture of true purchasing power returns, especially during periods of high inflation.

Conclusion

The bond yield definition is essential for every investor, beginner or seasoned. It provides valuable insight into a bond’s income potential and helps you compare risk-adjusted returns across assets. From current yield to yield to maturity, each metric plays a role in building a well-diversified portfolio. Bond yields also reflect broader economic conditions, such as inflation and interest rates, guiding smarter investment decisions. Always match the type of yield with your financial goal, whether it’s regular income or long-term returns.

Also Read: What is SGB?

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.