Bond Basics: An Investor's Guide to the Many Meanings of Yield
Let us assume that you are reading the financial pages of your favorite newspaper. You read that even though stock returns have been dismal for the last two years, bond returns have been very good. In fact, you read that over the past two years, many bond funds returned well over 15%. While the returns look pretty darn good relative to stocks, you may wonder: Does that mean I can expect to earn 15% next year if I buy bonds? If the answer is not obvious, read on.
The direction of interest rates is one of the chief determinants of bond prices. A strong market for bonds is one in which interest rates are declining. That causes bond prices to go up. A weak bond market is one in which interest rates are going up. That causes bond prices to decline. Clearly, then, since changes in interest rate levels affect bond prices, they also affect what you earn from investments in bonds.
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But that is only the beginning. In order to understand what you actually earn from bonds, you need to understand two different concepts: yield and total return.
When you buy an individual bond, you can expect to receive coupon payments (usually every six months) for most bonds and the par value of the bond upon maturity. When you buy a bond fund, you can expect a monthly payout of the income earned by the bond fund. That stream of income is variously described as the bond's "yield." But you also have to bear in mind that when you sell or redeem your bond (or bond fund), you may sell at a higher or at a lower price than the price you paid. That difference can be an additional source of earnings, or it may result in a loss. That change in price is one of the main factors that determines a bond's total return.
What may be confusing, however, is that the term yield has a number of different meanings. Even more confusing is the fact that these meanings are not directly comparable for individual bonds and for bond funds. Moreover, individual bonds are usually sold to investors and are discussed primarily in terms of yield, not returns. But discussions of bond funds often focus on total return. This article will try to bring some clarity to this topic.
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