A bond, simply defined, is a type of investment which is very similar to an IOU. It is a loan in the form of a security with two basic components, the face value (principle), and the coupons (interest rate). The bond is a contract between the issuer and the bondholder to pay certain amounts of money in the future. The issuer of the bond promises to pay the bondholder principle and interest according to the terms and conditions listing in the bond. Many cities and countries issue bonds to fund new highways and other such projects.
The definition of bond yield is the rate of return on the bond, which takes into account the sum of the interest payment, the redemption value at the bond’s maturity, and the initial purchase price of the bond. Yield on the bond relates to the return on the capital you invest in the bond. You will hear the term yield a lot as it relates to investing in bonds. There are many types of yields you’ll need to be aware of listed below.
- Current Yield
The current yield calculates the percentage of the return that the annual coupon payment provides to the investor. It calculates the percentage of the actual dollar coupon payment is of the price the investor pays for the bond. This can be easily found by dividing the bond’s coupon yield by it’s market price.
- Coupon Yield
The annual interest rate established when the bond is issued.
- Yield to Maturity
This is the return that the investor will receive from their entire investment in the bond.
- Yield to Call
Yield to call (YTC) is the interest rate that the bond holders would receive if they held the bond until the call date. The call date is the date on which a bond may be redeemed by the issuer before the bond’s maturity. If this happens, the bond will be redeemed at par or a higher value.
- Yield to Worst
This is the lowest calculated rate that the bond holder will receive upon maturity or call date. It is typically calculated by conservative investors to determine the worst case scenario.
Be sure to remember that once a bond is issued, the coupon interest rate is fixed. Therefore, if the market interest rates rise, then the price of the bond will fall so that the bond yield will be consistent with current market rates.