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Yield / Risk

In the context of bonds, the yield is the return produced over the entire duration. The yield has three components and constitutes a proportion of the invested capital:

  • Interest income
  • Income from reinvesting interest payments
  • Price gains/losses when the bond is sold/repaid

As with all investments, the expected yield depends on the risk of an investment. Because of the increased risk associated with long-term capital loans, investors usually expect higher yields from them than from short-term capital investments. Market rates change in response to economic trends and in doing so affect bond prices.

The yield on a bond is dependent on the bond price, the duration, the coupons and other factors such as the currency and the creditworthiness. The structure of the market rates for various durations has to be considered as well, because interest payments made over the duration can be reinvested at the current market rate (compound-interest effect).

The yield of a bond and its price move in opposite directions. If the market price of the bond falls, the yield rises and vice versa.

Yield Bond price
Rising Falling
Falling Rising

The example below deals with the direct yield, the price difference and the yield to maturity:

Interest rate 5.25%
Term to maturity 4.5 years
Current price 102.5%

Direct yield

The simplest measure of the interest rate on an investment is the direct (or simple) yield. It is calculated by comparing a payment (e.g. in the form of a coupon) to the price of the investment.

This formula applies to all fixed-rate investments. The term to maturity and the expected price gains or losses have no bearing on this formula, nor are accrued interest, draws or calls taken into account.

Yield to maturity

The yield to maturity indicates an investment's average annual yield. The formula involves the price gain (in the case of a purchase below par) or price loss (in the case of a purchase above par) and the term to maturity.

This is a simplified yield-calculation method for bonds that ignores future coupon payments and compound interest.

Yield curve

The structure resulting from stringing together market rates with different durations is described as the "yield curve". We distinguish between flat, rising and inverted yield curves.

  • Flat - the difference between short-term and long-term yields is small
  • Rising - the yields on long-term investments are higher than those on short-term investments
  • Inverted - the yields on short-term investments are higher than those on long-term investments

The rate difference between the two durations is called the "spread". The difference between the yield on the bond of a borrower with a first-class credit rating and that of one with a lower rating is called the "credit spread". Borrowers with lower ratings have to pay a premium compared to borrowers with first-class credit ratings.

This can be seen with the yield curve tool when government bonds are compared with interest rate swaps (which have the same credit rating as companies). Here there is a premium.