The Ins and Outs of Bond Yield

Step 2: Why Are There Different Bond Yields?

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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.

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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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