Bond yields

Introduction

Bond yield is one of the most important concepts in fixed-income investing. It helps investors understand the return a bond offers relative to its price and expected cash flows.

Yield can be confusing because there is more than one way to measure it. A bond has a coupon rate, but it may also have a different current yield and yield to maturity. The numbers can diverge whenever a bond trades above or below its face value.

Understanding these differences makes it easier to compare bonds and to see why bond prices usually move in the opposite direction from yields.

What is a bond yield?

A bond yield is a measure of the return associated with owning a bond. The exact meaning depends on which yield measure is being used.

For a basic bond, the investor may receive coupon payments and the repayment of face value at maturity. If the bond is purchased for a price other than face value, that difference also affects the investor’s return.

As a result, simply looking at the coupon rate does not always show what a bond is offering at its current market price.

Coupon rate vs yield

The coupon rate is the bond’s stated annual interest payment expressed as a percentage of face value. For example, a bond with a $1,000 face value and a 5% annual coupon pays $50 of interest per year if its terms call for a fixed annual coupon of that amount.

If the bond trades at exactly $1,000, the 5% coupon rate also equals a 5% current yield. But if its market price changes, the current yield changes even though the $50 annual coupon remains the same.

This simplified example illustrates a basic relationship: when the price falls and the coupon payment stays fixed, current yield rises. When the price rises, current yield falls.

Common bond yield measures

What yield to maturity tells you

Yield to maturity is more comprehensive than current yield because it accounts for coupon payments, the bond’s current price, the amount repaid at maturity, and the time remaining until maturity.

For example, a bond bought below face value may provide a return from both coupon payments and the difference between its purchase price and the amount repaid at maturity. A bond bought above face value has the opposite effect because the investor pays more than the amount ultimately repaid at maturity.

YTM is useful for comparing conventional bonds with different coupons, prices, and maturities, but it is still a calculated measure based on assumptions. Actual realized returns can differ, especially if the bond is sold early, payments are not made as promised, or coupon payments are reinvested at different rates.

Why bond prices and yields move in opposite directions

Suppose an existing fixed-rate bond pays a 4% coupon. If newly issued bonds with similar risk and maturity begin offering 5%, investors would generally prefer the new higher-paying bonds unless the price of the older bond falls enough to make its return more competitive.

If market rates instead fall to 3%, the existing 4% bond becomes relatively more attractive and its market price may rise.

This inverse relationship between price and yield is fundamental to bond investing. It also explains why a bond can decline in market value even when the issuer remains financially healthy.

What affects bond yields?

Bond yields reflect more than prevailing interest rates. Investors consider the time until maturity, expected inflation, the issuer’s credit quality, liquidity, and features such as call provisions.

For corporate bonds, investors often compare the yield with a government benchmark of similar maturity. The additional yield, commonly discussed as a credit spread, can compensate investors for risks that are not present to the same degree in the benchmark security.

Government bond yields themselves can also vary substantially across countries because economic conditions, currencies, inflation expectations, and creditworthiness differ.

Higher yield usually means higher risk

A higher yield can be attractive, but it should not be viewed as a free increase in return. Markets often demand higher yields when investors perceive greater credit risk, interest-rate risk, liquidity risk, or other uncertainty.

For example, a financially weaker company may need to offer more yield than a financially stronger borrower to attract investors. A long-term bond may also offer a different yield than a short-term bond because investors are committing capital for a longer period.

Evaluating yield therefore requires evaluating the risks behind it. Our guide to bond risks explains those tradeoffs in more detail.

Key takeaways

• Bond yield measures return relative to a bond’s price and cash flows.
• The coupon rate is based on face value, while current yield uses the bond’s current market price.
• Yield to maturity accounts for price, coupon payments, maturity value, and time to maturity.
• Bond prices and yields generally move in opposite directions.
• Actual realized returns can differ from quoted yield measures.
• A higher yield often reflects greater risk or uncertainty rather than a guaranteed better investment.