Investing Basics: Bond Yields

Bonds bring certainty to a portfolio because of the guaranteed future income payments they deliver over the lifetime of the loan, but investors can also benefit from bond prices rising in the secondary market – writes Christian Leeming

There are two main variables affecting demand for bonds and therefore their price – interest rates and sentiment around the risk of default of the bond.

As interest rates fall in the money markets, a bond paying a fixed rate of interest every year will become increasingly sought after by investors and its price will rise; the converse is also true, rising interest rates, particularly when coupled with inflationary pressure, render the fixed income from a bond unattractive and its price will fall.

the investor purchases a bond and is then guaranteed regular interest payments

In order to understand the present, it is useful to understand the past when, as bearer bonds, bond holders literally received a series of tear off coupons to redeem at predetermined dates when they became due.

Although payments may now be automated, fixed income investments essentially work in the same way; the investor purchases a bond and is then guaranteed regular interest payments, known as coupons, and a final repayment in full (redemption) at the end of the loan period.

In order to compare the returns delivered by different bonds there are a number of ways of measuring the relationship between the price of a bond and the yield received by an investor; £1,000 invested in a bond paying £80 per year in coupons delivers a yield of 8% – future cash flows are guaranteed but the price may fluctuate.

Income Yield

Income (sometimes ‘running’) yield describes the effective yield an investor achieves when buying a fixed income product at either above or below par.

If you bought a UK Treasury 5% Gilt at par you would know that every year to redemption you would receive two payments that would total a 5% return on your investment and that at the end of the loan period you would get your money back.

However, if you were to purchase the same product in the secondary market for 90% of its face value, the yield payments remain the same – 5% of the value at 100 – so the effective yield you receive is greater as a percentage of the price you paid.

Par/purchase price x coupon = running yield

In this instance:

Or 100/90 x 5% = 5.55% per annum.

If the price in the secondary market had increased to 110% of its face value, the effective dividend is diluted:

100/110 x 5% = 4.5% per annum.

Although coupon payments to the holder will still be £50, it is that as a percentage of the purchase price that changes if secondary market valuations fluctuate.

Simple Yield

Simple yield is a good rough guide to the return available on a bond and allows the comparison of products.

As an example, a bond with one year until redemption, paying a 5% coupon and purchased in the market for 95%.

The available return consists of two factors, the running yield over the remaining twelve month period of the loan and the profit made on maturity.

An investment of £950 would return the following:

£50 in coupon payments.

£1000 redemption payment made at par – a £50 profit.

The return on this twelve month investment would be £100 on £950, or 10.5%.
 

Yield to Maturity (YTM)

Yield to maturity is a more complex measure applied to longer dated bonds, which discounts the value of future cash payments according to when they are due; the calculation assumes that the interest payments received on the bond can be reinvested at the same rate, although this may not actually be the case.

Unlike simple yield, the yield to maturity formula would challenge all but the most arithmetically gifted, but there are sources of data available via platforms and sites specialising in fixed income that allow YTM and bond valuations to be compared.

Bond prices move as investors seek higher yield; bonds with many years to redemption are affected more than those approaching maturity.

The relationship between a change in yield and the resulting change in price is known as the duration of the bond.

When calculating the duration of a bond a weighted average of future payments is considered in light of various interest rate scenarios which produces a range of possible outcomes to be considered by a would be investor.

but investors demand an additional return for lending money to corporations

Corporate bonds display the same relationship between price and yield as government bonds, but investors demand an additional return for lending money to corporations due to the risk of default.

This premium over the equivalent government bond yield is known as the spread; high quality banks trade at a fraction over government bonds while the debt of smaller or risky companies may trade at a level returning several percent over an equivalent government bond.

This spread reflect the market’s view of the creditworthness of the issuer which can change quickly, adding price volatility to this type of bond over and above that determined by interest rate fluctuations.

Bonds are issued for periods ranging from three months through to 30 years or may be undated or ‘perpetual’ with no final maturity.
As interest rates change over time, bonds of different maturities have different yields based upon the market’s expectations for future interest rates; generally, investors receive a higher yield for longer term loans – longer dated bonds yield more than short bonds.