Bond yields 101: A guide for smarter investing

What are bond yields?

Bond yields are a measure of the return you can expect from a bond investment. A bond yield is a percentage that represents the annual income you receive from a bond relative to its current market price. Bond yields are influenced by factors like the bond's price, coupon rate, time to maturity, and market conditions. This metric is important because it helps you evaluate the attractiveness of a bond and compare it with other investment options.

There are different ways to calculate bond yields, with each calculation serving a specific purpose. While these calculations can seem complex, there are widely available calculators and spreadsheets that can do the heavy lifting for you, making it easier to understand and compare the yields on different bond investments

Learn more about different types of investments

Current yield

Current yield is a measure of the annual income your bond generates, in the form of interest or dividends, based on its current market price. Instead of focusing on the bond's face value, current yield uses the bond's current price to give you a more accurate picture of its potential return.

Essentially, the current yield tells you the return you could expect if you bought the bond and held it for one year; but it doesn't reflect the actual return you'd receive if you held the bond until it matures.

For example, if a bond with a face value of $1,000 and a coupon rate of 5% is currently priced at $1,100, the current yield would be $50 (the annual interest) divided by $1,100, which is about 4.55%. This gives you a sense of the bond's income potential, but the total return at maturity would depend on other factors, such as the bond's price at maturity and any capital gains or losses.

Yield to maturity

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It considers the bond's current price, its face value, the coupon rate, and the time to maturity. YTM is particularly useful because it provides a comprehensive view of a bond's potential return, allowing you to compare different bonds and make informed investment decisions.

The formula to calculate YTM is:

YTM = [ C+ (FV − PV) ÷ t ] ÷ [ (FV + PV) ÷ 2 ]

• C = Coupon payment
• FV = Face value
• PV = Present value/Current price
• t = Years to maturity

We'll use the previous example of a bond with a face value of $1,000 and a coupon payment of $50 per year, with a current price (present value) of $1,100—and let's say the bond is 10 years from maturity. Using the above formula, you'd get a YTM of 3.80%.

YTM = [50+ (1,000 − 1,100) ÷ 10 ] ÷ [ (1,000 + 1,100) ÷ 2 ]

YTM = 40 ÷ 1,050

YTM = 3.80%

YTM is a more accurate measure than the current yield, especially for bonds that aren't trading at their face value.

Bond equivalent yield

Bond equivalent yield (BEY) is a way to figure out the annual return on a short-term investment, like a Treasury bill, so you can compare it with longer-term bonds that pay interest on an annual basis. Since Treasury bills mature in one year or less, annual interest isn't an option.

By converting the yield to an annual rate, you can better assess the potential return and make more informed decisions about which bond might be the best fit for your investment portfolio.

The BEY formula takes the difference between the bond's face value and its current price, divides it by the current price to get the yield for the period, and then annualizes it by multiplying by the number of days in a year (365) divided by the number of days until the bond matures.

Here's what it looks like with the example we've been using above.

• Difference between $1,000 (face value) and $1,100 current price = $100
• Difference divided by current price, which in this case is $100 ÷ $1,100 = 0.09% (current yield)
• Now, to "annualize" the current yield, we multiply by the number of days in a year: 0.09% x 365 = 32.85
• We take the result (32.85) and divide by the number of days until maturity (10 years times 365 days gives us 3,650 days to maturity). We calculate 32.85 ÷ 3,650 = 0.009
• Then we multiply 0.009 by 100 to express as a percentage, which tells us the BEY is 0.90%.

Individual bond yields

An individual bond is a debt security issued by a government, corporation, or other entity. You're essentially loaning money to the issuer in exchange for regular interest payments and the return of your original investment when the bond matures. Keep in mind that there are exceptions to this. For instance, zero-coupon bonds don't have regular interest payments and amortized bonds don't return principal at maturity.

If you're investing in individual bonds, these are the types of yields you'll want to be aware of and understand:

Yield to call (YTC). The yield you'd receive if the bond were called before its maturity date. Callable bonds are bonds that the issuer can redeem early at a specified price and date. YTC is calculated similarly to YTM but assumes the bond is called at the earliest call date.

Yield to worst (YTW). The lowest potential yield an investor can receive on a bond without the issuer defaulting. It considers all possible call dates and other features that could affect the bond's return.

Effective annual yield (EAY). The annual rate of return that considers the effect of compounding. It's particularly useful for comparing investments with different compounding periods, meaning how often a bond makes interest payments.

Real yield. The nominal yield (the coupon rate) minus the inflation rate. It reflects the true purchasing power of the bond's return.

After-tax yield. The yield after accounting for taxes on the bond's income, which depends on the bond's tax status and the investor's tax bracket.

Bond mutual funds and ETF yields

A bond mutual fund or bond ETF is a basket of different bonds that you can buy into. It lets you spread your investment across many bonds, reducing risk and giving you the benefit of professional management, without having to pick each bond yourself. If you're looking at bond funds or bond ETFs, consider these metrics:

SEC yield. A standardized measure of a bond fund's yield, calculated according to rules set by the Securities and Exchange Commission (SEC). It's designed to provide a consistent and comparable way to evaluate the performance of different bond funds. The SEC yield for most bond funds is based on the fund's most recent 30-day period, but money market funds typically use a 7-day yield. This yield considers the interest income earned by the fund, minus the fund's expenses. It can give you an idea of how much you might earn from the fund in the future, but it's important to recognize that it's based on past performance and isn't guaranteed.

Distribution yield. A measure of the income a bond fund pays out to its investors, typically expressed as an annual percentage. It's calculated by taking the most recent distribution (dividend or interest payment) and annualizing it, then dividing by the fund's current net asset value (NAV). The distribution yield can give investors an idea of the current income they can expect from the fund. However, it can be influenced by onetime events, such as capital gains distributions, and may not always reflect the fund's long-term performance or stability.

Normal yield curve

A normal yield curve slopes upward, indicating that longer-term bonds have higher yields than shorter-term bonds. This is the most common shape and reflects the market expectation of stable or rising interest rates over time. 

Inverted yield curve

An inverted yield curve slopes downward, indicating that shorter-term bonds have higher yields than longer-term bonds. This is a less common shape and often signals that the market expects interest rates to fall in the future, which can be a sign of economic recession.

Flat yield curve

A flat yield curve shows little to no difference between the yields of short-term and long-term bonds. This can occur when the market is uncertain about future interest rates or economic conditions.

As an investor, you can use the yield curve to gauge the overall direction of interest rates and economic conditions. The shape of the curve can help you decide what types of bonds to include in your portfolio, balancing potential returns with risk and economic outlook.

For example, if the yield curve is steep, it might be a good time to invest in longer-term bonds for higher returns, while a flat or inverted curve might suggest sticking with shorter-term bonds to avoid potential losses.

High-yield bonds vs. investment-grade bonds

High-yield bonds, also known as "junk bonds," offer higher yields to compensate for their higher risk of default. These bonds are typically issued by companies with lower credit ratings. They're suitable for investors who are willing to take on more risk for higher returns.

On the other hand, investment-grade bonds (also known as high-grade bonds), such as government bonds or high-quality corporate bonds, offer lower yields but are considered safer investments. They're suitable for conservative investors seeking stable income.

What is a yield spread?

A yield spread is the difference in the yield (or return) between two different bonds, usually measured in basis points. It's a key metric for investors because it helps them gauge the risk and potential reward of different investments. For example, if you have two bonds with the same maturity date but different credit qualities, the bond with the lower credit rating will typically offer a higher yield to compensate investors for taking on more risk. So, if a high-quality bond yields 3% and a lower-quality bond yields 5%, the yield spread is 200 basis points (or 2%). This spread can help investors decide whether the extra return is worth the additional risk.

A yield spread can:

• Help investors understand the risk premium—the additional return that investors require to take on additional risk—associated with different types of bonds.
• Provide insights into market expectations and economic conditions.
• Help investors make informed decisions about bond portfolio diversification and risk management.

Other bond factors to consider

Credit risk

Credit risk is the risk that the bond issuer will default on its payments. Higher credit risk typically results in higher yields to compensate investors for the increased risk they're taking.

Liquidity

Liquidity refers to how easily a bond can be bought or sold without affecting its price. Bonds with higher liquidity may have lower yields because they're easier to trade.

Inflation

Inflation can erode the purchasing power of bond returns. Real yields, which account for inflation, are important for long-term investors to understand the true value of their returns.

Tax implications

The tax status of a bond can significantly affect its yield. For example, municipal bonds are often tax-exempt, which can make their after-tax yields more attractive to certain investors.

Interest rate risk

Interest rate risk is the risk that changes in interest rates will affect the bond's price and yield. Longer-term bonds are generally more sensitive to interest rate changes than shorter-term bonds.

By understanding these key concepts and yields, investors can make more informed decisions and better manage their bond investments. Whether you're a beginner or an experienced investor, these metrics provide valuable insights into the performance and risk profile of your bond portfolio.