Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.
While bonds are sold with a stated interest rate, there is more to the return than just the coupon rate. Let's look at what bond yields are along with what causes the yield to change and how a yield curve aids in bond investment evaluation.
Barry chose to include some bonds in his portfolio to have another class of investment besides his shares of stock. A bond is a form of investment where the issuer promises to repay the face value at a certain point in time and often gives periodic interest payments over the life of the bond. In many cases, investors buy bonds from another investor on the secondary market instead of from the original issuer. Let's help Barry identify the determining factors that influence his actual return on investment.
Bond yield measures an investor's actual return on investment. If Barry buys a 30-year savings bond from the government and cashes it in 30 years later, his yield is the same as the interest rate listed on that bond. If instead he buys a bond that was issued a few years ago, how can he figure out what is a good price or what his own personal yield is on the bond?
In order to find the yield, the investor needs to know what price the bond is worth today and the coupon rate and payment. In bond terminology, the interest rate paid out on a regular basis is known as the coupon. The amount of the coupon payment is determined by multiplying the interest rate by the original issue price of the bond. The yield itself is determined by the formula:
Yield = Coupon Payment / Price
Barry buys a new issue bond for $500 that has a 4% coupon rate. The coupon payment would be worth $20. The yield would be $20 / $500 = 4%. But what if the price of the bond rises or falls? That is where the bond yield shines as an investment return evaluation tool.
If the bond price falls to $460, the coupon payment still remains the same. The yield is now 4.3% ($20 / $460). The yield rises because the same guaranteed return is available at a lower price. Likewise, if the price of the bond rises to $540, the yield is now 3.7% ($20 / $540). In periods of economic uncertainty or recession, bond yields tend to fall as demand increases for safer alternatives to investing in stock. As the demand for bonds rises so does the price, leading to decreased yields.
The yield curve illustrates the concept that equivalent quality bonds will have yields that fall along a curve on a spectrum of different maturity dates. The maturity date is the time at which the bond issuer repays the face value of that bond.
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In a normal yield curve scenario, the further away the maturity date is in the future the higher the yield will be on that bond. Consider this: on a very short term, money can be lent at a low interest rate. But on a long-term loan, investors are going to want a stronger guarantee since rates will likely change over that long time period. The yield curve demonstrates how the increased risk of a longer term bond is rewarded with a higher interest rate.
A shift in the yield curve, such as flat rates across the range of maturity dates, can indicate economic uncertainty. If the normal yield curve is reversed and shorter term bonds begin issuing at higher interest rates than longer term bonds, it can be a sign of impending or current economic recession. The curve can also visually represent the spread of interest rates at different maturity points.
With bond investments the issuer of the bond agrees to pay the face value of that bond on its maturity date. When the bond is issued it has a stated coupon, or interest, rate that is paid to the investor periodically. The bond yield indicates the actual return on investment from that bond. If an investor buys a bond at a higher or lower sale price than the original offer, the yield adjusts to account for the different cost of obtaining that bond. As bond prices increase, yields decrease; likewise, as bond prices decrease, yields increase.
The yield curve shows how bond yields increase with progressively longer maturity dates under normal economic circumstances. The curve shifts and can reflect potential changes in the economy if yields remain flat over a period of time or even flip itself upside down in economic turmoil.
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