The Ins and Outs of Bond Yield
Step 2: Why Are There Different Bond Yields?
When you buy an individual bond, you derive income from three different sources:
Classroom Steps
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Step 1:
What Determines the Return on My Bond? -
Step 2:
Why Are There Different Bond Yields? -
Step 3:
How Is Yield to Maturity Calculated? -
Step 4:
What Makes Up My Bond's Total Return? -
Step 5:
Do Bond Funds Have a Yield to Maturity? -
Step 6:
How Should I Interpret My Bond's Reported Return?
- Simple interest,
- Interest on interest, and
- Return of principal at maturity, or proceeds from the sale of the bond at an earlier date.
Simple interest consists of the bond's coupons, which are usually paid twice a year. Let us say you invest $10,000 in a four-year bond, paying 8% a year, semiannually. In return, you will receive two coupon (or interest) payments of $400 each, at six-month intervals every year. If you hold the bond until it matures, you will receive eight coupons that total $3,200. Those eight coupons are the simple interest.
If the coupon payments are spent, only the simple interest is earned. But if the coupons are reinvested, they produce additional interest; subsequently, if those earnings are reinvested, you earn interest on that interest, and so on. That entire income stream is called, logically enough, interest-on-interest, or compounded interest. Both interest income, and interest-on-interest, in different combinations, lie behind the different meanings of yield.
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