What is bond yield and yield to maturity? Explain the relationship between yield and bond prices | Benefits of investing in bonds

When it comes to investing, a bond yield is the return you earn from a bond. The yield to maturity, or YTM, is the most comprehensive measure of bond yield, as it reflects the total annualized return you receive, assuming you hold the bond to maturity. Yields demonstrate a fundamental and inverse relationship with bond prices, meaning that when the price of a bond rises, its yield falls and when the price of a bond falls, its yield rises. While bond prices may fluctuate, benefits of investing in bonds include that they typically provide a reliable income stream, principal preservation and diversification benefits to your overall investment portfolio which can mitigate overall risk.

What is Bond Yield?

The bond yield is the amount of return that an investor anticipates receiving from holding a bond that is expressed as a percentage of the bond’s price. The yield reflects the income (primarily, the interest payments, or coupons) generated by the bond as compared to the current market price of the bond. There are several forms of bond yield, but the current yield is the most common, and it is calculated as follows:

Current Yield = (Annual Coupon Payment / Current Market Price) × 100

For example, if a bond pays $50 annually in coupons and its market price is $1,000, the current yield is (50 / 1,000) × 100 = 5%.

What is Yield to Maturity (YTM)?

The Yield to Maturity (YTM) is a broader measure of a bond’s return to an investor. It indicates the total annualized return that an investor will earn if they purchase a bond at its market price and hold it until maturity, assuming that all coupon payments are reinvested at the same rate and that the bond is held to maturity. YTM varies in its components from the coupon payment:

• The bond’s coupon payments.
• The difference between the bond’s current price and its face value (par value) at maturity.
• The time remaining until maturity.

YTM calculation is based on an intricate equation that takes into account the bond’s price, its coupon rate, its face value, and when the bond will mature. YTM is the bond’s internal rate of return (IRR) of the cash flows. For instance, a bond purchased at a market price below par value (and therefore at a discount) will have a YTM that is above the bond’s coupon rate because the investor receives coupon payments and participates in price appreciation to par at maturity.

Relationship Between Yield and Bond Prices

There is an inverse relationship between bond yields and bond prices. This is a critical concept to understand when investing in bonds:

• If yields increase, bond prices fall. When market rates of interest increase, newly issued bonds will issue at higher coupon rates, which would make the existing bonds with lower coupon rates likely less attractive to investors. Consequently, the price of the existing bonds would fall in order to match the yield of the newly issued bonds.
• If yields decrease, bond prices go up. When market rates of interest decrease, newly issued bonds will be issued with lower coupon rates, making existing bonds with higher coupon rates more valuable and prices will rise.

For example,

• A bond with a $1,000 par value offers a 5% coupon which means it pays $50 annually. If market interest rates rise to 6%, you can purchase new bonds at par value that would pay you $60 in interest (i.e. 6%). To earn that yield on the existing bond, its price would fall below $1,000, so the interest payment of $50 represents a yield that is equivalent to the new bond yield.
• If the interest rate declined to 4%, you can purchase new bonds paying interest (4%) of $40. The $50 interest payment of the original bond makes it more attractive compared to the new bonds, and consequently, the price of the original bond would increase to a price above $1,000 to factor its higher yield.

This inverse relationship is due to market demand and supply dynamics for price changes now, and YTM changes based on yield. In addition, because YTM incorporates the price of the bond relative to par value at maturity, the YTM is particularly influenced by the price variation.

Benefits of Investing in Bonds

Bonds are a popular investment for a variety of reasons, offering several advantages:

• Reliable Source of Income: Bonds generally provide a steady stream of interest (coupon payments), giving a reliable source of income that is very suitable for income-oriented investors like retirees.
• Preserve Capital: High-quality bonds (e.g. government and investment-grade company bonds) pose a low risk, so they can be used to preserve capital more effectively than stocks.
• Diversification: Bonds often have a low or negative correlation with stocks, which tend to dampen decline and proceeds when stocks are volatile.
• Predictable Returns: If held to maturity, bonds pay back the face value (assuming they don’t default on it). This creates a level of certainty with return when compared with equities.
• Variety of Choices: There is an array of bonds (government, corporate, municipal, etc.) that vary in levels of risk, maturities, and return, giving some scope to target something specific with the bond mix in a portfolio.
• Inflation Protection (Some Bonds): Certain bonds, like Treasury Inflation-Protected Securities (TIPS), will adjust their principal or payments based on inflation, at least partially protecting purchasing power.
• Tax Benefits: Certain bonds, like municipal bonds, may provide tax-free interest income that minimizes taxes for investors in a higher tax bracket.

Conclusion

In simple language, bond yield represents the return you get from a bond’s interest payments to its price, while yield to maturity (YTM) is the overall return if you hold the bond till maturity. Bond prices and bond yields move in opposite directions, yields increase, prices fall, or yields fall prices increase. The great thing about investing in bonds is that they provide a reliable income stream, take care of your money, provide a diversified denominator to your portfolio, and give predictable returns. Some bonds even carry tax benefits or inflation protection making them a great analytics for many investors.

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