What it means
Every bond has a face value, meaning the amount repaid when the loan matures, and a coupon, meaning the fixed interest paid each year. The coupon never changes, but the price of the bond moves in the market, so the return to a buyer today depends on what that buyer pays rather than on what the original lender paid.
Three versions of the number get quoted in practice. Nominal yield is simply the coupon rate, current yield is the annual coupon divided by the market price, and yield to maturity folds in the gain or loss made when the face value is finally repaid.
Yields matter well beyond the bond market. Government bond yields are the reference rate that banks price corporate loans against, so a finance director watching yields climb already knows the cost of the company's next borrowing facility is climbing with them.
Price and yield move in opposite directions, which surprises most people the first time they see it. If a bond paying $50 a year costs $1,000 the yield is 5%, but if nervous selling pushes the price to $800 that same $50 represents a 6.25% yield to whoever buys at the lower level.
The gap between a company's bond yield and the government bond yield of the same maturity is called the credit spread, and it is the market's price for the risk of not being repaid. A widening spread on your own bonds is an early warning that lenders have cooled on the business, often well before a ratings agency reacts.
In practice
Real-world examples.
Example
A pension fund holds a supermarket group's bonds bought at par with a 4% coupon. Interest rates rise, the bonds fall to $92 per $100 of face value, and the fund's paper valuation drops even though the yield to a new buyer has improved to about 5.9%.
Example
A regional manufacturer plans a bond issue and watches five year government yields move from 3.2% to 4.4% over a quarter. Its bankers now expect the company to pay roughly 7% rather than 5.8%, which adds about $360,000 of annual interest on a $30,000,000 issue.
Example
A treasury team compares two five year corporate bonds yielding 6.1% and 8.9%. The extra 2.8 percentage points is the credit spread the market demands for the weaker issuer, so the team buys the lower yielding bond because the extra income does not cover the default risk.
Formula
Calculation
Current yield = annual coupon / market price
Approximate yield to maturity = (annual coupon + (face value - price) / years to maturity) / ((face value + price) / 2)
Take a bond with a face value of $1,000 paying a 5% coupon, so $50 of interest a year, with five years left to run. Investors have grown wary of the issuer and the bond now trades at $900.
The current yield is $50 / $900 = 5.56%, already better than the 5% printed on the bond. Yield to maturity also counts the $100 discount recovered at maturity, spread across five years: $100 / 5 = $20 a year. That gives ($50 + $20) / (($1,000 + $900) / 2) = $70 / $950 = 7.37%.
So a buyer at $900 earns roughly 7.37% a year, provided the issuer keeps paying the coupon and repays the full $1,000 on time.Case study
Seen in the real world.
The following is an illustrative and entirely fictional scenario. Harrowgate Utilities, an invented water and waste business, issued $50,000,000 of ten year bonds with a 4% coupon, paying $2,000,000 of interest a year. The bonds sold at face value because investors saw regulated revenue and predictable cash flow.
Four years later the fictional regulator cut the tariffs Harrowgate could charge, and its bonds fell to $82 per $100 of face value. Current yield for a new buyer became $4.00 / $82 = 4.88%, and yield to maturity rose to roughly 8%, because the buyer would also collect the $18 discount when the bonds matured in six years.
Nothing about the coupon had changed, and Harrowgate's cash interest bill stayed at $2,000,000. What had changed was the market's view of the risk, and the practical consequence appeared when the company tried to refinance: new lenders quoted around 8%, doubling the cost of the next tranche of borrowing.
Watch out
Common mistakes.
- Confusing the coupon rate with the yield, when the coupon is fixed at issue and the yield changes every time the bond price moves.
- Comparing bonds on current yield alone, which ignores the gain or loss at maturity and flatters short dated bonds trading above face value.
- Assuming a high yield means a good investment, when unusually high yields normally reflect a market that expects the issuer to struggle.
Questions
People also ask.
Why do bond prices fall when interest rates rise?
Newly issued bonds pay the higher rate, so older bonds with lower coupons must get cheaper until their yield matches what a new buyer could earn elsewhere.
What is yield to maturity in plain terms?
It is the annual return you would earn if you bought the bond today, held it to the end, and the issuer paid everything owed on time.
Does yield tell you anything about a company's financial health?
Yes, indirectly: a rising yield on a company's existing bonds means investors are demanding more compensation for the risk of lending to it.
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