2.6 Yields

Bond Yields

Understanding bond yields is essential for comparing bond investments and appears frequently on the SIE exam. Different yield calculations tell you different things about a bond's return, and the relationships between these yields reveal whether a bond is trading at a premium or discount.

Types of Bond Yields

There are four main yield calculations you need to know:

Nominal Yield: Also Called - Coupon Rate; What It Measures - Annual interest as % of par value

Current Yield: Also Called - CY; What It Measures - Annual interest as % of market price

Yield to Maturity: Also Called - YTM, Basis; What It Measures - Total return if held to maturity

Yield to Call: Also Called - YTC; What It Measures - Total return if bond is called early

Nominal Yield (Coupon Rate)

Nominal yield is the annual interest rate stated on the bond certificate. It never changes over the life of the bond.

Nominal Yield = Annual Interest divided by Par Value

Example: A 7% bond pays $70 per year in interest (7% x $1,000 par). The nominal yield is always 7%, regardless of what happens to the market price.

The nominal yield is simply the coupon rate - the rate established when the bond was issued.

Current Yield

Current yield measures the annual return based on the bond's current market price, not its par value.

Current Yield = Annual Interest divided by Current Market Price

Example: A bond with a 6% coupon ($60 annual interest) trades at $950.

Current Yield = $60 / $950 = 6.32%

Current Yield vs. Nominal Yield

At par ($1,000): Nominal = Current Yield

At discount (below par): Current Yield greater than Nominal Yield

At premium (above par): Current Yield less than Nominal Yield

Yield to Maturity (YTM)

Yield to maturity (YTM) is the total return an investor will receive if they hold the bond until maturity. It accounts for:

- Annual interest payments

- Any capital gain or loss at maturity

- Time value of money

YTM is considered the most comprehensive measure of a bond's return.

Key Point: YTM assumes the investor reinvests all interest payments at the same rate. The actual formula is complex and will not be tested - focus on understanding the concept and relationships.

YTM and Bond Prices

Par bond: YTM = Coupon Rate

Discount bond: YTM greater than Coupon Rate

Premium bond: YTM less than Coupon Rate

Yield to Call (YTC)

Yield to call (YTC) calculates the return if the bond is called (redeemed early) at the first call date. This is relevant for callable bonds.

- Uses call price instead of par value

- Uses call date instead of maturity date

- Important when a bond trades at a premium

When YTC Matters: If a bond is trading at a significant premium, investors should calculate YTC because the issuer is likely to call the bond if interest rates have fallen.

The Yield Relationships (Critical for Exam)

The relationship between the four yields tells you whether a bond is at premium or discount. This is heavily tested on the SIE exam.

Discount Bond Yield Order

For bonds trading at a discount (below par):

NY < CY < YTM < YTC

Memory Tip: Discount bonds have "increasing yields" as you move from nominal to YTC.

Premium Bond Yield Order

For bonds trading at a premium (above par):

YTC < YTM < CY < NY

Memory Tip: Premium bonds have "decreasing yields" as you move from nominal to YTC - the opposite of discount bonds.

Par Bond Yields

When a bond trades at par, all yields are equal:

NY = CY = YTM = YTC

The Bond See-Saw (Visual Memory Aid)

Think of yields like a see-saw:

Discount (Price less than Par): NY < CY < YTM < YTC; Yields increase

Par (Price = Par): All yields equal; Balanced

Premium (Price greater than Par): YTC < YTM < CY < NY; Yields decrease

Quick Calculation Examples

Current Yield Practice

Bond A: Coupon 5% ($50); Market Price $1,000; Current Yield - $50 / $1,000 = 5.00%

Bond B: Coupon 6% ($60); Market Price $900; Current Yield - $60 / $900 = 6.67%

Bond C: Coupon 8% ($80); Market Price $1,100; Current Yield - $80 / $1,100 = 7.27%

Notice: Bond B (discount) has CY greater than NY. Bond C (premium) has CY less than NY.

Key Takeaways

- Nominal yield (coupon) is fixed and never changes

- Current yield reflects today's return based on market price

- YTM is the most complete measure of return (includes capital gain/loss)

- YTC applies to callable bonds and uses the call price

- Discount bonds: NY < CY < YTM < YTC

- Premium bonds: YTC < YTM < CY < NY

- Know the yield relationships - they are frequently tested!