Bond yields

The bond yield measures the future income due to the investor, adjusted for the current price and the time left until the maturity date. The price and yield of a bond are related. When the price of a bond rises, the future yield (based on the price) will fall, and vice versa.

What is the average return on bonds?

The price of a bond changes depending on the value of its known, regular coupon payment when compared to interest rates in the wider economy. If an investor can earn the same, or higher, interest rate for holding cash than a bond, the attractiveness of the bond will fall. Consequently, so will its market price.

On the other hand, if interest rates (or interest rate expectations) start to fall, then the known, regular coupon payment from the bond becomes more attractive. This means the price of the bond will rise. These movements affect the average return an investor receives from their bonds.

What are the different types of bond yield?

Running yield

The running yield is also called the income yield. It's calculated by dividing the value of the coupon payment by the current price of the bond.

The face value is the amount the issuer will repay to the investor at maturity.

Although the running yield is a useful comparison of ongoing income, it doesn’t factor in what happens if you hold the bond to maturity. In other words, the end profit or loss isn’t included.

Redemption yield

A bond’s yield to maturity measures the total return from the investment if it’s held until maturity. It considers all the income payments and the capital return, and discounts each payment (cashflow) to adjust for when it’s received. The most accurate way of calculating yield to maturity requires a spreadsheet or complex financial calculator.

However, you can use a simple yield-to-maturity calculation to get a good indication of the total return. It adjusts the running yield calculation above for the difference in the price and the face value of the bond.

Though this formula considers whether the bond is currently priced above or below par, it doesn’t discount the value of each coupon payment (cash flow) over time. Not using a discount rate means it becomes less accurate for longer-dated bonds.

If maturity is many years away, the most accurate way to analyse the yield would be by undertaking a full redemption yield to maturity calculation using a financial calculation or similar software.

Bond duration

The bond's duration measures the relationship and sensitivity of a bond's price to a given change in its yield. It examines the time to maturity and the coupon payments, indicating a bond’s interest rate risk. A higher duration suggests a greater expected rise or fall when interest rates change.

The price of bonds with longer to run until maturity will be more sensitive to changes in interest rates. That’s especially true if the coupon is relatively low.

If interest rates are rising, the rate investors can get with cash might look more attractive than the fixed interest amount offered by the bond over the long term. This could lead to a fall in the market price as investors sell the longer-dated bonds.

The opposite can also be true. If interest rates are falling, the fixed coupon of the bond starts to look more attractive to investors, particularly over the long term. This could cause demand for longer-dated bonds. Then, the price they fetch can rise quicker than shorter-dated bonds offering the same coupon rate.

The longest duration is found in long-dated bonds with lower coupons. Similarly, the shortest duration is in shorter-dated bonds with higher coupons.

Clean prices and accrued interest

The yield formulas for the other types of yield mentioned here use the ‘clean price’. This is the quoted price of a bond on the secondary market. The clean price does not include any accrued interest between coupon payments.

If you’re partway through a coupon period (they’re usually made twice a year), you’ll need to adjust it to reflect income accrued to the bond. The actual price you will pay will include accrued interest and the cost of the bond (known as the ‘dirty price’).

If you buy a bond immediately after the issue or the most recent coupon, the clean and dirty prices will be the same.