The yield is the annualised rate of income based on the purchase price and the capital flows promised by the issue. The yield of a bond is the rate that balances the price of the issue with the current value of the future revenue that the bond will provide.
The calculation of the yield takes into account three revenue sources of a bond :
- Coupon payment
- Capital gains or losses (difference between the purchase and redemption price)
- Coupon reinvestment
The yield makes it possible to compare different bonds to a certain extent. In a way, it’s the measure of the performance of the issue under two relatively strong hypotheses :
- The issue is held up to maturity
- The coupons are reinvested at a rate equal to the calculated yield.
The yield formula is the same as that used to calculate the price of a bond :
- Cpn: Amount of paid coupon
- Rbt: Redemption value
- YTM: Yield to maturity
- Freq: Number of coupons paid per year
- N: Total number of coupons to be received
- a: Fraction of year covered by the accrued coupon
The yield and price provide the same information. If one is known, the other can be calculated. The key ratio of the bond market is shown in the following graph :
Example :
Which of the two bonds below would you buy ? |
