Why you Need to Calculate Bond Yield and How to Do it
By Acceler8now.com Bond Investing Team, August, 2007
A bond has its coupon, which is the interest rate on the bond. Interest payment, over the term of the bond, is at that rate, except in the case of floating rate bonds. Yet, even with fixed rate bonds, bond yield is still computed. Why is this so, when there is a stated rate of interest which easily says what the earnings on the bond will be? Well, it isn't that straigth-forward, because a number of factors affect the real yield of the bond, beyond what is on its face. That is why, as a bond investor or an intending one, you need to understand the basis of bond yield calculation and learn to compute it.
Understanding the Basics
The bond you buy has a face value, which is the principal sum of the investment. Usually, this is N1,000. It also has a term, which is the duration of the bond. The maturity is the date on which the bond is due for repayment. The investor that holds the bond to the maturity date will receive repayment of the principal amount, that is, the face or par value of the bond. The last payment of the coupon will also be received with it.
However, because there is bond trading in the secondary (resale) bond market, there is a current market price for a bond, which will not necessarily be the same as its face value.
Bond prices fluctuate, especially in response to underlying interest rate trends in the economy. Current buyers are likely to buy at a discount or premium, since the current market price may be lower or higher than the face value. For instance, an investor could buy at 105%, which implies a premium of 5% and actual purchase price - the current market price - of N1,050. With that scenario, the relationships obviously change: if I buy now at N1,050 and the coupon is, say, 10%, the yield will no longer be same as to the investor who intially bought at N1,000. What moves the price? As stated, market interest rate trend is a major factor. Take a bond issued with coupon of 17.5% in 2005, when that reflected the interest rate level. If, today, interest rates are much lower and a currently issued bond would be in the coupon range of 12%, that shows a huge positive margin of 5.5% for the 2005 bond. The holder of such bond will certainly expect a premium in selling that bond, since the purchaser gets the benefit of acquiring a bond that can earn 17.5%.
Bond prices consequently move in opposite direction to interest rates. When current interest rate goes down, the price of the bond will be expected to go up. That's how market shifts alter the current market price of a bond and that throws up various computations of yield for a bond.
Nominal Yield
This is the coupon rate - the interest rate on the bond.
If a bond has a coupon of 12%, that is the nominal yield.
If nothing was to change about a bond, this is rate. But then, a lot of things change over the term of a bond, affecting its price, ownership, etc. These substantially diminish of value of the nominal yield as a measure of returns on the bond.
Current Yield
This is a ratio of annual interest payment to current market price of the bond. This measure considers that a current buyer at the present market price is probably paying a different price from the par value. The yield relevant to him is therefore one that is based on the price he actually pays. The annual interest payment is therefore divided by the current price:
Current yield will be equal to nominal yield where the bond is purchased at the par value. However, current yield is based on the annual interest payment and does not figure in subsequent payments on the bond to maturity. A current buyer wishing to calculate his return for the year, would use this measure which is based on the actual market price. However, it fails to determine the yield on the bond over its entire term. If you wished to compare the investment with other investment options to which the capital sum can be applied, this rate falls short. Consequently, this metric is obviously not comprehensive in appraising the investment, which is why another measure of bond-yield, viewed as a more important representation of its true yield, is computed. That is the yield to maturity.
Yield to Maturity
The yield to maturity incorporates all the interest payments to be received from the bond, up to the maturity date. It is the total return that a bond will earn if it is held till maturity and if all interest is assumed to be re-invested at the yield-to-maturity rate. It also incorporates the gain or loss on the purchase price - as a difference between the par value received at maturity and the actual purchase price. The computation assumes holding the instrument to maturity and non-default in payment of interest and principal on due dates. That is why it is viewed as the most appropriate parameter to evaluate bond-yield, especially when comparing different bonds. It is however a fairly involved calculation which bond calculators are your best bet for. Fortunately, there are free online calculators, like this one, and others for free download. However, a close approximation is given by this formula:
 Yield to Call
Some bonds allow the issuer to repay the bond before its maturity date. Such bonds are referred to as callable. Because they may not be held to maturity, the yield computation will allow for this by applying an assumed call date. Yield to call is similar to yield to maturity, but calculated to a call date.
Summary
Bond yield and its calculation is obviously one of the most difficult aspects of the subject. However, yield is important in the evaluation the investment, which is why it's difficult to run from the subject. Calculating bond yield is now simplified by the availability of calculators that do so, which are also readily available online. So, determining yield will not stop you from taking decisions as whether to invest in bonds.
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