Bonds are among the many safe investment options available in the financial market. Typically, investors with a risk profile that’s majorly risk-averse consider investing in bonds. But given this, there are also many risk-aggressive investors who shop in the bond market in an attempt to diversify their investment portfolio and balance the risk therein. So, no matter what your risk profile may be, it’s a good idea to understand what bonds are all about.
While you’re at it, getting to know what the bond yield is may be a good place to start. Many investors often wonder about the bond yield meaning when they’re reading up on possible bonds to invest in. If you’ve also been clueless about the bond yield meaning, then this guide will help you understand this concept better.
Let’s get started.
What is bond yield?
In the simplest words, bond yield is simply the returns that an investor obtains from a bond. In its most basic form, the bond yield would be equal to the coupon rate. You’ll perhaps recall that the coupon rate is the rate at which interest is paid out on a bond. Now, since the interest payments earned are essentially the returns obtained from a bond, the coupon rate is the simplest kind of bond yield.
Now that you know the bond yield meaning, it’s time to look beyond the definition and get to know this concept a bit better.
Understanding bond yield better
Equating the bond yield with the coupon rate may be easy to understand, but in truth, it’s not that simple. The bond yield is a more layered concept because metrics like the time value of money and compounding interest payments all come into the picture. This paves the way for more complex calculations like the yield to maturity and the bond equivalent yield. Let’s take a look at these two metrics.
Yield to maturity (YTM)
The yield to maturity for a bond is basically the total return that an investor can expect from a bond if that bond is held until maturity. This means that the investor does not trade the bond in the secondary market. Rather, they hold the bond till its maturity date. So, the yield to maturity for a bond takes into account all future cash flows expected till maturity, such as the interest payments as well as the value at maturity. The YTM is that rate at which the present value of such future cash flows equals the prevailing price of the bond.
Bond equivalent yield (BEY)
Many bonds pay out interest twice a year, on a semi-annual or half-yearly basis. The bond equivalent yield becomes relevant for such bonds. The following formula can be useful if you’re looking to calculate the bond equivalent yield.
|Bond equivalent yield = [(Face value – purchase price) ÷ Price of the bond] x (365 ÷ number of days till maturity)|
To understand this better, let’s look at an example. Say an investor buys a bond with a face value of Rs. 1,000 for Rs. 900. And say that the number of days till maturity is six months or 183 days. Then, here’s how the BEY shall be calculated.
BEY = [(1,000 – 900) ÷ 900] x (365 ÷ 183)
This comes up to around 22%.
The link between bond yield and bond price
Mathematically as well as conceptually, the bond yield and the bond price share an inverse relationship. When the price of a bond goes up, the yield reduces. And vice versa. Typically, if you’re looking to invest in a bond, you will look for bonds with low prices, and consequently, higher yields. Conversely, if you’re looking to sell a bond instead, you may likely wait for an opportunity where the price of the bond is high, so you can cash out with greater gains. Instead, if you plan to hold the bond till maturity, you may perhaps wish for greater bond yields, so your overall returns remain on the higher side.
As an investor, it’s important for you to understand the different ways in which bond yields are computed. This way, you can make a more informed decision about which bond to invest in and when to invest in it. It also gives you a fair idea of when you sell your bond, in case you do not plan to hold it till maturity. Understanding the concept of bond yield can help you make smarter investment decisions overall.