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:
- Simple interest,
- Interest on interest, and
- Return of principal at maturity, or proceeds from the sale of the bond at an earlier date.
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 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.