Bonds are debt securities issued by institutions such as governments and corporations to borrow money. A bond’s yield, or rate of return, can be measured using several different methods. The method you choose depends on what you need to know about a particular bond.
Bonds pay a fixed amount of interest annually called the coupon. A bond is issued at a stated par value and the interest percentage, called the coupon rate or coupon yield, is calculated by dividing the coupon by the par value. For example, a bond with a coupon of $65 and a par value of $1,000 has a coupon rate of 6.5 percent. The coupon rate is the stated rate of return for the bond.
A bond can be traded on bond markets after it is first issued. As bonds are bought and sold, their prices fluctuate. When you purchase a bond for a price that is different from the par value, your rate of return changes. This is because you invest an amount of money that is different from the par value but you get the same amount of interest. The actual rate of return you get is called current yield. Suppose you buy a $1,000 par value bond with a $65 coupon at a discount for $800. The current yield is equal to the $65 coupon divided by the $800 price, which works out to 8.13 percent. Your rate of return is higher than the coupon rate because you get the same amount of interest with a smaller investment. If you buy a bond at a premium above the par value, your current yield will be lower than the coupon rate.
Suppose you buy a bond at a discount and hold it until it matures. Your rate of return includes the interest the bond earns plus additional profit you make, because the bond issuer must pay you the full par value to pay off the matured bond. Yield-to-maturity is an estimate of the total return on a bond investment that takes into account possible gains and losses due to the bond’s price as well as interest. Yield-to-maturity estimates assume you hold the bond to maturity and that you reinvest all dividends at the same rate of return.
Municipal bonds issued by state and local governments are generally exempt from federal income taxes and often from state income taxes as well. Investors use a measure called tax-equivalent yield to compare the tax-free rate of return on a municipal bond to the pretax yields of taxable bonds. Suppose a tax-free municipal bond has a current yield of 5.1 percent. To compute the tax-equivalent yield, first subtract the highest income tax rate you pay from 1. If you are in the 25 percent tax bracket, this is 1 minus 0.25, leaving 0.75. Divide the municipal bond’s 5.1 percent yield by 0.75, which gives you 6.8 percent. This means a taxable bond needs a yield greater than 6.8 percent to provide a better after-tax rate of return.