If interest rates rise, then the price of the bond must decrease to remain competitive with other investments, and vice versa. The price of the bond will also depend on the creditworthiness of the issuer, which indicates the risk of the investment. The higher the credit rating of the issuer, the less interest the issuer must offer to sell its bonds. The prevailing interest rate — the cost of money — is determined by the supply and demand of money. As for virtually everything else, supply and demand determine price, so for bonds, the greater the supply and the lower the demand, the lower the price of the bond and, correspondingly, the higher the interest rate, and vice versa.
An often used measure of the prevailing interest rate is the prime rate charged by banks to their best customers. Most bonds pay interest semi-annually until maturity, when the bondholder receives the par value, or bond principal , of the bond back. Zero coupon bonds pay no interest, but are sold at a discount to par value, so the interest, which is the difference between par value and the discounted issue price, is paid when the bond matures.
Nonetheless, the yield of the zero coupon bond is the annualized return, which allows it to be compared to coupon bonds. Nominal yield , or the coupon rate , is the stated interest rate of the bond. Because bonds trade in the secondary market, they may sell for less or more than par value, which will yield an interest rate that is different from the nominal yield, called the current yield , or current return.
Since bond prices move oppositely of interest rates, bond prices decrease when interest rates increase, and vice versa. To see why, consider this simple example. Bonds selling for less than par value are said to be selling at a discount. If the market interest rate of a new bond issue is lower than what you are getting, then you will be able to sell your bond for more than par value — you will be selling your bond at a premium.
Note, however, that the bond price is based on the clean price , meaning that any accrued interes t is excluded, since that will be paid to the bond owner on the next interest payment. The interest from municipal bonds is not taxed by the federal government, and U.
Treasury bonds, notes, and T-Bills do not incur state or local taxes. Hence, these bonds can pay a lower interest rate than a corporation with a comparable credit rating. To compare municipal bonds or Treasuries with taxable bonds, the yield is converted to a taxable equivalent yield TEY , sometimes called equivalent taxable yield. The taxable equivalent yield is the yield that a taxable bond must pay to be equivalent to the tax-free bond.
We can call this the federal taxable equivalent yield, but note that if you live in the municipality of the bond issuer, then the bond may be free of state and local taxes as well. To take in consideration all taxes saved, the above formula can be extended for any tax situation by simply adding up the percentages to arrive at a composite tax bracket and use that in the above equation to get the tax-free yield. A tax-free municipal bond yielding 6. At maturity, you'll receive full face value and a final interest payment.
Calculating a bond's nominal yield to maturity is simple. Take the coupon, promised interest rate, and multiply by the number of years until maturity. Multiply the coupon rate by the face value; then multiply by years to maturity. This equation equals the. This is a 14 percent nominal yield to maturity. Effective yield calculations consider how often the bond pays interest during a year. Divide the coupon rate by the number of interest payments each year and add one. Then square the result.
Effective yield takes into account the power of compounding on investment returns, while nominal yield does not. The effective yield is a measure of the coupon rate, which is the interest rate stated on a bond and expressed as a percentage of the face value. Coupon payments on a bond are typically paid semi-annually by the issuer to the bond investor.
This means that the investor will receive two coupon payments per year. Effective yield is calculated by dividing the coupon payments by the current market value of the bond.
Effective yield is one way that bondholders can measure their yields on bonds. The drawback of using the effective yield is that it assumes that coupon payments can be reinvested in another vehicle paying the same interest rate. This also means that it assumes the bonds are selling at par. This is not always possible, considering the fact that interest rates change periodically, falling and rising due to certain factors in the economy. The yield-to-maturity YTM is the rate of return earned on a bond that is held until maturity.
On the other hand, if the YTM is less than the effective yield, the bond is selling at a premium. Investors can find a more precise annual yield once they know the BEY for a bond if they account for the time value of money in the calculation.
This is known as an effective annual yield EAY. However, the effective yield is a measure of return on a bond assuming the coupon payments are reinvested. If payments are reinvested, then his effective yield will be greater than the current yield or nominal yield, due to the effect of compounding. Reinvesting the coupon will produce a higher yield because interest is earned on the interest payments.
The formula for calculating effective yield is as follows:. Running Yield. Nominal Yield. Yield to Maturity YTM. Yield to Call YTC. Yield to Worst YTW. SEC Yield. The Bottom Line. Key Takeaways A bond's yield refers to the expected earnings generated and realized on a fixed-income investment over a particular period of time, expressed as a percentage or interest rate.
There are numerous methods for arriving at a bond's yield, and each of these methods can shed light on a different aspect of its potential risk and return. Certain methods lend themselves to specific types of bonds more than others, and so knowing which type of yield is being conveyed is key. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear.
Investopedia does not include all offers available in the marketplace. Related Articles. Fixed Income Essentials When is a bond's coupon rate and yield to maturity the same? Coupon Rate: What's the Difference? Holding Period Return. Partner Links. What Is a Coupon Rate? A coupon rate is the yield paid by a fixed income security, which is the annual coupon payments divided by the bond's face or par value.
Yield Yield is the return a company gives back to investors for investing in a stock, bond or other security.
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