Those who enter the bond market as an investor typically seek a stream of income. From an individual bond, this income comes in the form of semiannual coupon payments. From a bond fund, it comes from the fund’s distributions. The stream of income that a bond or bond fund provides is characterized as its yield, but the term has different meanings for the two types of securities.

A bond’s yield is one of two parts that make up a bond’s total return; the other is the principal, which is returned at the bond’s maturity or through the capital gain or loss realized from disposing of the bond prior to maturity.

For individual bonds, there are three primary aspects of yield: coupon yield, current yield and yield to maturity (YTM).

Coupon Yield

The coupon yield—also known as the coupon rate—is set at a bond’s issuance. It is the interest rate paid by the bond listed as a percentage of the principal, or par value of the bond, designating a fixed dollar amount. If a bond with a par value of $1,000 is described as having a 3% coupon, the annual interest payment will be $30 for each bond. For bonds issued in the U.S., this means that semiannual payments of $15 each—a total of $30 per year—will be paid out for the entire life of the bond. This is why bonds are called fixed-income securities. No matter what happens to the price of the bond, or to interest rates, the coupon for a traditional bond will not change.

(Note: Some bonds are floating-rate bonds. These adjust the interest rate paid out based on a specified metric, such as inflation. Most bonds have fixed coupons, however.)

The coupon yield relates to a bond’s simple interest, which consists of the coupons paid regularly during the year. If you invest $20,000 in a four-year bond, paying 3% a year semiannually, in return you will receive two coupon (or interest) payments of $300 each, at six-month intervals every year. If you hold the bond until it matures, you will receive eight coupons that total $2,400, making up the bond’s simple interest.

If the coupon payments are spent, only the simple interest is earned. If the coupons are reinvested, they produce additional interest, which compounds over time. That entire income stream is called interest-on-interest, or compounded interest. Both interest income and potential compound interest are behind the different meanings of yield in different combinations.

Current Yield

Current yield is a bond’s annual income from the coupon payments divided by its market price. A large secondary market exists for bonds, and bonds are frequently traded at a price that is different than their par value.

As an example, say you purchase three bonds with par values of $1,000 and 2.5% coupons. The first bond was bought at par value. But the second bond was bought at a discount to par value for $900 and the third bond was bought at a premium to par value for $1,200.

Dividing the coupon of $25 from each bond by its market price gives different current yields for bonds that are otherwise the same. The bond at par value has a current yield of 2.5%. The bond bought at a discount to par value has a current yield of 2.78% and the bond bought at a premium to par value has a current yield of 2.08%. Current yield is quoted for fixed-income securities of any maturity.

Current yield doesn’t measure compound interest and capital gains or losses, which are important to consider.

Yield to Maturity

Yield to maturity is the measure widely quoted when selling individual bonds. But it is not a guarantee of what you will earn on a bond in total. Yield to maturity relies on certain conditions or assumptions:

• the bond is held to maturity,
• the coupons are reinvested (compound interest) and
• the coupons are reinvested at an interest rate equal to the yield to maturity at a given time.

The total return you realized from an investment in bonds is likely to differ from its yield to maturity because of these assumptions. If you spend the coupons, then you will not benefit from compound returns. How much your total return varies from the yield to maturity depends on the extent to which you spend the interest payments, whether you reinvest the coupons at the coupon rate and the maturity of the bonds.

Outside of the calculation for yield to maturity, you cannot know at the time you buy a bond what the reinvestment rate is going to be. You don’t know where interest rates will be in the future. The uncertainty is greater for bonds with longer maturities and higher coupon rates since the amount represented by the interest-on-interest becomes greater on a percentage basis.

YTM quotes allow you to compare different kinds of bonds, those with dissimilar coupons, different market prices relative to par value (premiums or discounts) and different maturities.

The connection between yield and price is important to understand. When a bond carries a higher coupon rate than the prevailing interest rates, buyers will pay more than the par value of the bond for the higher coupon. They are willing to pay a premium in order to lock in the higher interest rate paid by the bonds.

Interest rate levels directly affect 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.

This potential change in the interest rate is known as “reinvestment risk.” You may have to reinvest the income received from coupons at a lower interest rate. This causes your actual total return to be lower than the yield to maturity quoted at the time of purchase. On the other hand, you may benefit from accepting the uncertainty of the reinvestment rate if you are able to reinvest the income from your bonds at a higher interest rate. That would increase the actual return above the yield to maturity quoted at the time of purchase.

Investors demand more yield the riskier a bond is.

Bond Funds

Individual bonds and bond funds are often considered interchangeable from the standpoint of portfolio allocation, but there are important differences between the two.

All bond funds quote a yield. However, the yield quoted for bond funds is not equivalent to the yield to maturity quoted for individual bonds.

Unlike individual bonds, there is no date at which the entire portfolio of a bond fund matures. (An exception is defined-maturity bond funds, which mature around a pre-specified date.)

Many bond funds seek to maintain a maturity of a specified length. If a bond fund invests in long-term bonds, then bonds are bought and sold continually to maintain a portfolio average long-term maturity. Some bond funds, however, have the flexibility to adjust their target maturities based on the manager’s assessment of the market and economic environment.

Without a single maturity date for the entire portfolio, bond funds cannot quote a YTM equivalent to that of individual bonds.

The yield quoted by bond funds is basically a variant of the current yield quoted for individual bonds. Yield for bond funds is calculated using a formula determined by the U.S. Securities and Exchange Commission (SEC). It is an annualized average of the distribution income (that is, the interest distributions) paid by bonds in the fund over the past 30 days. It also includes slight price increases for discount bonds or price decreases for premium bonds. Bear in mind, these are past returns.

The price of a bond fund changes continually in response to changes in interest rates. Those changes may be minor for some types of bond funds but major for many others—for example, the prices of bond funds with a long-term average maturity are more sensitive to changes in interest rates. As a result, the price of any bond fund at any future date is impossible to predict.

Conclusion

Bond yield can be defined in different ways, but always relates to the income that a bond or bond fund provides. The yield can be the simple coupon yield, ignoring compound interest and changes in the bond’s price, or can be the more complex yield to maturity.

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