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DYK: different types of fixed income yields

LiveMint logoLiveMint 21-05-2014 Lisa Pallavi Barbora

In the world of fixed income, the term ‘yield’ comes up very often. At times it is used too liberally without context. In simple terms, yield on a security means its return. However, if you get into the details, you will see that for a coupon paying bond, return depends on your holding period. Follow this primer to understand what return you earn on your bonds or bond funds.

Coupon

This is the most basic form of yield. Majority of bonds specify a fixed coupon rate when issued. For example, a 12% XYZ Ltd 10-year non-convertible debenture (NCD) has a coupon of 12%. The coupon is expressed in terms of the annual interest on the security. This is the fixed interest that the issuer will pay the bond holder and is indicated at the very beginning. While the coupon is expressed in terms of annual return, it may be paid out monthly, quarterly, semi-annually or at any other frequency indicated by the issuer. If you buy an NCD from the capital market at face value and hold it till maturity without reinvesting the income, your return can effectively be expressed in terms of the annual coupon rate.

Current yield

This is more important if you need to sell or buy bonds in the secondary market or in case of debt mutual fund portfolios. At the time of issue, the face value of a bond is considered as its price. But after listing, there is a market value or a market price that the bond is traded at. Current yield takes into account market price rather than face value and is calculated by dividing the annual return by the current market price. For example, if the annual interest to be earned on a bond is `10 and the bond (face value `100) trades at a current market price of `110, then the yield is 9.10%.

This yield shows the return you will earn if you buy the bond now and hold it for a year. The current yield is lower than the coupon if the market price is higher than the face value and vice versa. But keep in mind this talks of the yield today; if you do end up selling the bond after a year, although you will earn 9.1%, your final return will depend on the price you sell the bond at.

You can apply this to an entire portfolio, say, for your debt funds, to arrive at an average yield that the portfolio offers. You can then get a rough indication of what you can earn from a portfolio of securities if held for a year.

Yield-to-Maturity

This is the return you will earn if you hold the bond till maturity. However, it is a complicated calculation. It takes into account the bond’s coupon, its current price, face value and the yield. There is also an inherent assumption that every annual coupon received will be reinvested for the remainder (till maturity) of time at a constant rate that is usually equal to the yield on the bond. It is the present value of future cash flows in context to the market price of the bond. This is an important metric for analysing other factors such as security yield curves.

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