How To Calculate Bond Yield
Learning to calculate a bonds rate of return or yield starts with understanding the different rate indicators involved. Bond yields are based on the coupon rate, the price paid and the maturity length of the investment.
The 3 key interest indicators are: Nominal Yield, Current Yield, and Yield to Maturity.
The Nominal rate or coupon rate is the fixed interest rate on the bond. This is the rate that the issuer pays to par value. It is fixed, it never changes and it is only paid to par. Par is the amount of bonds you own. This yield may or may not be your total net rate of return. If the bond was purchased at a premium (above par), then your overall yield to maturity will be lower than your stated coupon rate.
If a bond has a 7% nominal yield or coupon and was purchased at a premium of $103 ($1030), then your YTM will calculate lower because the 7% interest is only paid to the $1000 par. The $30 premium does not earn interest and is not redeemable at par. So, a 7% bond at a premium is not really "yielding" 7% in that example.
A bond purchased at a discount will have the reverse affect on yield. The Yield to maturity would be higher for a discount bond, based on the fact that you are still earning interest on par even if you paid under par. The overall YTM wil calculate higher for a bond.
How important is the Coupon Rate on Bonds?
The coupon or nominal rate's main advantage is income. That high fixed rate does not change. However the higher the coupn rate, the higher the price for the bond vs. news issues of the same maturity and quality. New issues will come out at or near par, so the nominal yield will reflect current market rates on similar bonds.
The current yield on a bond is calculated by dividing the nominal rate by the current market price. Doing this will have a similar result to the yield to maturity when bonds are bought at premiums or discounts. A premium bond will have a lower current yield compared to it's coupon rate and a discount bond will have a higher current yield than it's nominal rate.
A bonds current status is fairly unimportant. Most bonds are held to maturity, sold or called away. In the end, it is income, price and ytm.
Yield To Maturity
The most important rate of return indicator is a bond's yield to maturity. The YTM factors in everything to give the true overall yield to an investor.
It examines the nominal yield, current yield and years to maturity. The overall rate of return can be effected by the length of time the bond is held. If a 4 point premium was paid on an 8% bond, but the bond has a maturity of 15 years, that yield will be different than if the bond was only good for 2 years.
This is also most important in non callable bonds. Bonds that are callable before the maturity date means they might not go to maturity, and thus a Yield to Call should also be examined.
How to calculate yield to maturity:
This is done by using the key components of a bond: the coupon rate, the price and the years to maturity. A 5% bond priced at $850 and maturing in 15 years would calculate as follows:
Yearly Coupon Interest = $50 (5% paid to $1000)
Total Discount = $150 ($100 par - cost of $850)
Annual Discount = $10 ($150 total discount divided by 15 years)
Average price - $925 (difference between $850 and $1000 par)
Add the $10 annual discount to the coupon payment of $50. This gives you $60, which is divided by $925 and that will give you the yield to maturity of this bond - 6.49%
Tax Equivalent Yield Calculator
The after tax yield or tax equivalent is used with Municipal Bonds mostly. Since the interest on municipal bonds are federally tax free, a tax equivalent yield is needed to compare municipals with other taxable investments that may be in front of an investor. An example we can calculate would be comparing a 6% municipal with an 8% corporate bond. The tax bracket for this example is 28%. You need to calculate the tax free yield on the municipal
and then compare it to the 8% stated yield on the corporate bond.
Municipal yield divided by 100 minus the tax bracket will give you the after tax yield equivalent. 6% divided by 72 (100-28) will equal 8.33%, which is greater than the 8% corporate bond.
Callable YTC - Call Bonds
Fixed income securities or bonds that are callable may be priced to their yield to call. This date, if called is basically an early maturity for the bondholder. The one key difference is that notes or bonds that go to maturity always mature to par, so the yield is calculated with that in mind.
Callable securities could be called at different prices than par. The yield to call will be higher than the nominal yield if the bond is called at a price above the price paid by the investor originally. The YTC will be lower if the reverse is true. Similar to par non callable bonds, if a fixed income investment was bought at par and is called at par - the yield to call will equal the nominal rate.
Putable - Put Bond
Some bondholders may own a feature within thei investment that allows then to "put" the security back to the company on certain dates or beginning on certain dates. This feature keeps the power in the investor's hands. If Interest rates rise, bond prices go down because your nominal coupon rate is now not as attractive as new issues. If the debt is putable, you can redeem it early and the company has to pay you off. These are pretty rare as it locks the company into a bind and then has
to re-issue new bonds at higher interest rates. Government bonds are not issued like this, nor are municipal bonds as most municipalities could put themselves in a bad hole,
but low grade High Yield Corporate bonds may have to resort to offering a put feature to lower the bond price and help it get sold.
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