Calculating Bond Yields

While tax implications are important, most people are probably more concerned with the pre-tax return on their investments. In the case of bonds, that means knowing how to work out whats known as the bonds yields. So, lets start with a couple of definitions. A $10,000 bond that you buy for $10,000 is said to have been bought at par. A $10,000 bond that you buy for less than par, say $9,500, is said to have been bought at a discount. While a $10,000 bond you buy for more than par, say $11,000, is said to have bought at a premium. Current Yield Current yield is the annual income expressed as a percentage of the cost or market price. All bond yields are calculated based on $100 par, regardless of how large a bond an investor holds. So if a bond has a coupon of 8% and you paid $10,000 for it, your current yield is: 8 100 = 8% But if you paid $11,000 for the bond your current yield would be: 8 110 = 7.27% Conversely, if you paid $9,500 for the bond, your current yield would be: 8 95 = 8.42% Current yield is a useful measure, as it can be compared to the current yield of other investments such as income trusts or preferred shares. However, if you intend to hold the bond to maturity, current yield is not so useful as it changes everyday based on the current price of the bond. An investor intending to hold a bond until maturity has locked in the final price of the bond already par. Yield to Maturity But, with most bonds, this relationship is complicated by the assumption that youll be repaid the par value of your investment at maturity. Unlike a stock yield, a bond yield not only reflects your return in the form of income, but also includes any capital gain or loss realized when the bond matures. So, a bond yield to maturity is made up partly of income and partly of capital gain or loss. The bond you bought for $9,500 will mature and pay you $10,000, giving you a capital gain of $500. The bond you bought for $11,000 will also mature and pay you $10,000, leaving you with a capital loss of $1,000. Approximate Yield to Maturity A more precise bond yield can be determined by averaging the purchase price with the redemption price, which is par or $100. The formula for approximate yield to maturity is:
interest income + annual price change 100 (purchase price + 100) 2

For example, lets calculate the yield on a 10% $5,000 bond maturing in eight years that was purchased at $92. What is the annual interest income based on $100 par?
$100 10% = $10

What is the annual price change based on $100 par? The bond was purchased at $92 and will mature at $100. So, it will increase over the remainder of its life by $8.00. Since there are eight years to maturity, the annual price increase of this bond will be $1.00 per year.

($100 $92) 8 = $1

What is the average price based on $100 par? The purchase price was $92 and the bond will mature at $100. The average price then equals:
($92 + $100) 2 = $96

All pre-written articles are for the exclusive use of practising FCSIs and remain the property of CSI Global Education (2003). Unauthorized use or duplication of these articles by persons who are not practising FSCIs is prohibited and subject to penalties provided by law. CSI Global Education Inc. (2003)

Therefore, the approximate yield to maturity on a 10% $5,000 bond maturing in eight years that was purchased at $92 is:
$10.00 + $1.00 100 ($92 + $100) 2 $11.00 100 = 11.46% $96

Yield to Maturity using the Present Value Method Remember, though, that this is a rough method of calculating yields and your investment advisor will communicate to you a much more precise yield calculation using the present value method rather than the approximate yield to maturity method. The present value method calculates the present value of all the cash flows (interest and principal) an investor will receive over the life of the bond. This yield is the one that is reported in the newspaper and is the one used when trading in the bond market. Why do bond prices move in the opposite direction of bond yields? When a bond is first sold as a part of a new issue, the price is fixed. From then on, the price of a bond moves up or down relative to changes in the general level of interest rates. When interest rates rise, the price of a bond goes down because its coupon rate (the fixed, periodic payment) becomes less appealing in comparison to the higher coupon rates of newly issued bonds of similar quality. Conversely, if interest rates fall, the bond's coupon rate becomes more attractive to investors, which drives up the price. If the yield to maturity is greater than the coupon rate, the bond will sell at a discount to its maturity price. If the yield to maturity is less than the coupon rate, the bond will sell at a premium to its maturity price. Also, the longer the maturity of the bond, or the smaller the coupon rate, the more its price tends to be affected by changes in interest rates.

What are these yields telling you? When youre buying a bond, your investment advisor will quote you the price, years to maturity, the coupon rate, the bonds current yield and yield to maturity. These quotes will tell you different things. First, the coupon rate will tell you how much income you will receive per year. The current yield will tell you how much interest income you will receive in relation to the price youre paying for the bond. The yield to maturity will estimate the total return of the bond, assuming you dont sell it prior to maturity and that all coupon payments are reinvested. Dont forget that the approximate yield to maturity is just that, an approximation and it wont be your actual return. The more precise yield to maturity figure, using present value methodology is a more accurate measure of the return you are earning on the bond, but it too, assumes that you can reinvest the interest income at the same rate. Your actual return will be determined by a number of factors, including whether you are going to spend your interest income or reinvest it and at what rate. Hopefully, the term yield and its numerous meanings have been clarified. But, just to be on the safe side, talk to your investment advisor. The yield of a bond is only one of the many factors you should consider when choosing an investment in bonds.

All pre-written articles are for the exclusive use of practising FCSIs and remain the property of CSI Global Education (2003). Unauthorized use or duplication of these articles by persons who are not practising FSCIs is prohibited and subject to penalties provided by law. CSI Global Education Inc. (2003)