Part 20: Bond Yield

Welcome back to The Apricot Investor’s Glossary! In this post, we’re diving into a fundamental concept in the world of investing: yield. You’ll often encounter this term when discussing investments that can provide you with regular income, like bonds and dividend-paying stocks. Understanding yield is crucial for assessing the potential return on your investment.

What is Yield?

Simply put, yield represents the income generated by an investment over a specific period, expressed as a percentage of the investment’s current market price or, in some cases, its face value. It essentially tells you how much income you’re receiving relative to what you paid for the investment.

Think of it this way: if you buy something for $100 and it pays you $5 in income each year, the yield would be 5%.

It’s important to note that yield is different from the total return, which also includes capital appreciation (an increase in the investment’s value). Yield focuses solely on the income component.

The concept of yield can be applied to various asset classes, and the specific calculation might vary slightly. In this example we will look at an example with bonds.

Let’s recall some important things related to bonds:

When you buy a bond, you’re essentially lending money to a company or government. In return, the issuer promises to pay you back the principal (the original amount you invested) at a future date (the maturity date). But that’s not all! They also agree to pay you regular interest payments, known as coupons, over the life of the bond.

The coupon rate is the annual interest rate that the bond issuer promises to pay. It’s usually expressed as a percentage of the bond’s face value (the principal amount). For example, if a bond has a face value of $1,000 and a coupon rate of 5%, you’ll receive $50 in interest each year.

Coupon payments are typically made semi-annually, meaning you’ll receive two payments of $25 each year. However, the frequency can vary depending on the bond.

Bond Yield (Current Yield) measures the annual coupon payment (interest payment) of a bond as a percentage of the bond’s current market price.

The annual coupon payment is calculated by multiplying the coupon rate by the face value. The face value of a bond (also sometimes called par value) is the original amount of money the bond issuer promises to pay back to the bondholder when the bond reaches its maturity date (the date when the loan ends). However, the price you pay for a bond in the market (current market price) can be different from its face value, because the bond could be available on the market at a higher or lower price than its face value. That’s why we use the current market price to calculate the current yield:

Current Yield= Annual Coupon Payment / Current Market Price of Bond ​×100%

For example: Imagine a bond with a face value of $1,000 and a coupon rate of 5%. This means it pays an annual interest of  $50 ($1,000 * 5%). Now, let’s say you can buy this bond in the market for $950 (this is its current market price). The current yield would be:

$50/$950​×100%≈5.26%

This shows that even though the bond’s stated interest rate is 5% based on its face value, your actual return based on what you paid ($950) is higher at 5.26%.

It’s worth noting that other bond yields, like yield to maturity, take into account the bond’s face value, time to maturity, and any capital gains or losses if held until maturity.

Why is Yield Important?

Comparing the yields of similar investments can help investors identify potentially undervalued or overvalued assets. A higher yield might suggest a bargain, but it could also indicate higher risk.

It’s crucial to consider it alongside other factors like the overall financial health of the issuer, potential for capital appreciation, and your own investment goals and risk tolerance.

It’s important to remember that investments are subject to market fluctuations and carry inherent risks. Consider your financial goals and risk tolerance before investing.

Apricot Capital is regulated by the Central Bank of Armenia.

The examples in this text are for illustrative purposes only. This does not constitute investment advice or a recommendation to buy or sell any specific investment instrument. The past performance mentioned in this text is not indicative of future results.