What Is Bond Yield?

Definition

Bond yield is the return an investor can expect from a bond, calculated as the ratio of the annual interest payment to the bond's current market price, a concept rooted in capital asset pricing model developed by William Sharpe in 1964.

How It Works

The bond yield is influenced by the bond's face value, coupon rate, and time to maturity. For instance, a bond with a face value of $1,000 and a coupon rate of 5% will pay $50 in interest annually. If the bond's market price increases to $1,200, the yield will decrease to 4.17%, illustrating the inverse relationship between bond price and yield. The yield curve, which plots bond yields against their maturities, is a key indicator of market expectations for interest rates and economic growth, with a normal yield curve sloping upward from short-term to long-term bonds, as observed in the US Treasury yield curve.

As bond yields change, they impact the overall cost of borrowing for companies and governments. For example, when bond yields rise, the cost of issuing new debt increases, making it more expensive for companies like Apple to issue bonds to finance their operations, with Apple's debt financing costing around 3.5% in 2020 (Apple annual report). The term structure of interest rates, a concept introduced by Irving Fisher in 1930, also influences bond yields, as longer-term bonds typically offer higher yields to compensate investors for the increased risk of lending for an extended period.

The bond yield is also affected by credit risk, with bonds issued by companies with lower credit ratings, such as Junk bonds, offering higher yields to compensate investors for the increased risk of default. The credit spread, which is the difference between the yield on a corporate bond and a comparable government bond, reflects the market's assessment of the company's creditworthiness, with Moody's and Standard & Poor's providing credit ratings that influence the credit spread.

Key Components

• Coupon rate: the interest rate paid periodically to the bondholder, which affects the bond's yield, with higher coupon rates resulting in higher yields.
• Time to maturity: the length of time until the bond expires, which influences the bond's yield, with longer maturities typically offering higher yields.
• Market price: the current price of the bond in the market, which affects the bond's yield, with higher market prices resulting in lower yields.
• Credit rating: the assessment of the issuer's creditworthiness, which impacts the bond's yield, with lower credit ratings resulting in higher yields.
• Inflation expectations: the market's expectations of future inflation, which influence the bond's yield, with higher inflation expectations resulting in higher yields to compensate investors for the loss of purchasing power.
• Central bank policies: the actions of central banks, such as the Federal Reserve, which impact bond yields through their influence on interest rates and money supply.

Common Misconceptions

Myth: Bond yields are only influenced by interest rates — Fact: Bond yields are also affected by credit risk, inflation expectations, and central bank policies, as evident in the European sovereign debt crisis, where bond yields in countries like Greece and Italy were heavily influenced by credit risk.

Myth: Bond yields are always higher for longer-term bonds — Fact: In some cases, such as during periods of high inflation or economic uncertainty, the yield curve can become inverted, with shorter-term bonds offering higher yields than longer-term bonds, as observed in the US Treasury yield curve in 2000.

Myth: Bond yields are only relevant for investors — Fact: Bond yields also impact the overall economy, as they influence the cost of borrowing for companies and governments, with Boeing's cost of debt financing affecting its ability to invest in new projects.

In Practice

In 2020, the US Treasury issued a 10-year bond with a yield of around 1.8%, attracting investors seeking a relatively safe investment with a stable return. The yield on this bond was influenced by the Federal Reserve's monetary policy, with the Fed's decision to keep interest rates low affecting the bond's yield. The bond's yield also reflected the market's expectations of future inflation, with the Consumer Price Index (CPI) rising by around 2.3% in 2020, influencing the bond's yield to compensate investors for the expected loss of purchasing power. As a result, investors who purchased the bond at its issuance were able to earn a return of around 1.8% per annum, with the bond's yield providing a relatively stable source of income in a low-interest-rate environment.