David Lerner Associates: Bond Yields and the Yield Curve

Current yield

People sometimes confuse a bond’s yield with its coupon rate (the interest rate that is specified in the bond agreement). A bond’s coupon rate represents the amount of interest you earn annually, expressed as a percentage of its face (par) value. If a $1,000 bond pays $50 a year in interest, its coupon rate would be 5 %.

Current yield is a bit different. It represents those annual interest payments as a percentage of the bond’s market value, which may be higher or lower than par. As a bond’s price goes up and down in response to what’s happening in the marketplace, its current yield will vary. If you were to buy that same $1,000 bond on the open market for $900, its current yield would be 5.55 % ($50 divided by $900).

If you buy a bond at par and hold it to maturity, the current yield and the coupon rate are the same. For a bond purchased at a premium or a discount to its face value, the yield and the coupon rate are different.

If you’re concerned only with the amount of current income a bond can provide annually, then calculating the current yield may give you enough information to decide whether you should purchase that bond. If you’re interested in a bond’s performance as an investment over a period of years, or want to compare it to another bond or some other income-producing investment, the current yield will not give you enough information. In that case, yield to maturity will be more useful.

Yield to maturity

Yield to maturity is a more accurate reflection of the return on a bond if you hold it until its maturity date. It considers not only the bond’s interest rate, principal, time to maturity, and purchase price, but also the value of the interest payments as you receive them over the life of the bond.

If you buy a bond at a discount to its face value, its yield to maturity will be greater than its current yield because along with receiving interest, you would be able to redeem the bond for more than you purchased it. The reverse is true if you buy a bond at a premium (more than its face value). Its value at maturity would be less than you paid for it, which would affect your yield.

Yield to maturity lets you accurately compare bonds with different maturities and coupon rates. It’s particularly helpful when you’re comparing older bonds being sold in the secondary market that are priced at a discount or at a premium instead of at face value. It’s also especially important when looking at a zero-coupon bond, which typically sells at a deep discount to its face value but makes no periodic interest payments. Because all of a zero’s return comes at maturity, when its principal is repaid, any yield quoted for a zero-coupon bond is always a yield to maturity.

Watching the yield curve

Bond maturities and their yields are related. Typically, bonds with longer maturities pay higher yields. Why? Because the longer a bondholder must await the bond’s principal to be repaid, the greater the risk compared to an identical bond with a shorter maturity, and the more reward investors demand.

On a chart that compares the yields of, say, Treasury securities with various maturities, you would typically see a line that slopes upward as maturities lengthen and yields increase. The greater the difference between short and long maturities, the steeper that slope. A steep yield curve often occurs when investors expect a faster-growth economy and rising interest rates; they want greater compensation for tying up their money for longer periods. A flat yield curve means that economic projections are relatively stable, so there is little difference between short and long maturities.

Material contained in this article is provided for information purposes only and is not intended to be used in connection with the evaluation of any investments offered by David Lerner Associates, Inc. This material does not constitute an offer or recommendation to buy or sell securities and should not be considered in connection with the purchase or sale of securities. Member FINRA & SIPC

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Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and can not be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

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Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2014