A1.6.3. Yield
A bond’s yield is its actual rate of return to the investor. This figure is not necessarily the same as the bond’s coupon or interest rate, although the coupon is a key factor in determining the yield. The coupon rate of a bond is the bond’s nominal yield, which is what the yield would be if the bond were trading at par. Since the market prices of bonds fluctuate, the actual yield and the nominal yield are rarely the same. Yield is often measured in basis points. If a bond’s yield rises from 4.3% to 4.6%, its yield has risen by 30 basis points.
A bond’s current yield (CY) is the actual income rate of return on a bond. It is computed as follows:
SAMPLE QUESTION
A bond has a par value of $1,000 and pays a 6% coupon rate. If the market price of the bond rises to $1,200, what is the bond’s current yield?
Answer: 5%. A bond with a par value of $1,000 and a 6% coupon would pay interest of $60 per year. If the market price of the bond rises to $1,200, the current yield of the bond is $60 divided by $1,200, or 5%.
This example illustrates the inverse relationship between the changes in the price of a bond and its yield. If the bond price goes up, its yield falls, because it now costs more to obtain the same amount of interest. If the price of a bond falls, its yield rises, because the buyer can now get the same annual payment at a lower price. For example, if the price of the bond in the example fell to $800, the yield would rise to 7.5% ($60 / $800).
These examples also show why bond prices change in response to changes in prevailing interest rates. If interest rates rise, and an investor could purchase a $1,000 bond that pays 7.5%, she would have no incentive to pay $1,000 for an older bond with a 6% coupon. The market price of the bond must adjust accordingly—as in the example, to about $800—to provide the same yield.
Say interest rates drop to 4% instead. The holder of the bond paying 6% is now earni