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:
What Determines the Return on My Bond?
Why Are There Different Bond Yields?
How Is Yield to Maturity Calculated?
What Makes Up My Bond's Total Return?
Do Bond Funds Have a Yield to Maturity?
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.
To read more, please become an AAII member or CLICK HERE.