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Corporations and governments sell bonds to borrow money. Investors typically buy these bonds for the interest income they provide. "Bond yield" is the rate of return you can expect to make from a bond. However, there are several ways to measure bond yield, so there are several definitions of the term.
The amount of interest a bond pays is referred to as its coupon. Coupon yield or coupon rate is the proportion of the bond’s par value that the bond pays, expressed as an annual percentage rate. When you buy a bond at exactly par value, coupon yield is the annual rate of return you get. For example, a bond with a $1,000 par value that pays a coupon of $56 per year has a coupon yield of 5.6 percent.
After a bond issuer sells bonds, they can be traded on the bond market. Investors bid bond prices up and down in response to market forces. Current yield is the return, or effective interest rate, that you get when you buy a bond at a price other than the par value. The current yield is equal to the coupon divided by the price.
Suppose you buy a $1,000 bond with a $56 coupon at a price of $800. Dividing the coupon by the price gives you a yield of 7 percent. This illustrates a basic feature of yields: When prices drop, yields go up and vice versa. In this example, the reason is that you invest less money to get the same coupon, so the yield is better.
When a bond matures, the bond issuer pays it off at par value. If you buy a bond at a price other than par value, this means you will realize a gain or loss if you hold the bond until maturity. Yield-to-maturity is a measure of the return on a bond that factors in this potential gain or loss, along with the current yield, to arrive at an estimate of your overall return.
When you buy a bond at a discount, yield-to-maturity is higher than current yield because it allows for the gain you would get by holding the bond until it matures and receiving the full par value. Conversely, yield-to-maturity is always lower than current yield when you pay a premium price that’s greater than the par value.
Yield-to-maturity calculations are estimates that assume the bond will be held to maturity and that your interest payments are reinvested at a rate equal to the yield-to-maturity.
Why Yields Vary
Bond yields tend to follow market interest rates. When interest rates go down, an existing bond becomes a more attractive investment. Demand increases and investors bid up the bond price, resulting in a lower yield. The opposite happens when market interest rates go up.
Investors also keep a sharp eye on a bond issuer’s credit rating. If the rating is downgraded, bond prices tend to fall. This drives up the yield up until investors think the higher return justifies the added risk.
Price changes are greater for long-term bonds with several years remaining until maturity. Short-term bonds and bonds close to their maturity dates tend to have prices close to par value, because investors will soon be paid off and changes in market interest rates and credit risk have less impact.