Section 3.2 — Bond Yields and Features

  • 💡 What Is a Bond Yield?

    • A bond yield measures how much income (interest) an investor earns from a bond relative to its value or price.

    • Yields vary depending on:

      • Bond rating (credit quality/safety)

      • General interest rates

      • Time to maturity

      • Special features (call, put, convertible, etc.)

      Because bonds can trade at a discount or premium, the yield must reflect both the interest income and any gain or loss from buying or selling at prices other than par.

📊 Types of Bond Yields

1. Nominal Yield (Coupon or Stated Yield):

  • Set at the time of issue.

  • Fixed percentage of par value.

  • Example: A bond with a 6% coupon and $1,000 par value pays $60 per year.

2. Current Yield:

  • Measures annual interest relative to current market price.

  • Formula:

    • Current Yield = (Annual Coupon Payment ÷ Market Price)

    • Example: $60 coupon ÷ $1,200 price = 5% current yield.

3. Yield to Maturity (YTM or Basis):

  • The total annualized return if the bond is held to maturity.

  • Considers:

    • Annual interest payments.

    • Gain/loss from buying at discount or premium.

  • If bought at discount, investor earns extra at maturity.

  • If bought at premium, investor loses some value at maturity

4. Yield to Call (YTC):

  • Applies to callable bonds that the issuer can redeem before maturity.

  • If called, investor receives principal back early.

  • Calculated like YTM but assumes earliest call date..

5. Basis Points:

  • 1 basis point (bp) = 1/100 of 1% = 0.01%

  • 100 basis points = 1%

  • Used to measure small yield changes.

  • Example: A change from 5.00% to 5.25% = 25 basis points.

💸 Price–Yield Relationship

  • Inverse relationship:

    • When bond prices go up, yields go down.

    • When bond prices go down, yields go up.

  • The effect depends on whether the bond trades at:

    • Par

    • Discount

    • Premium

Bonds

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🧩 Bond Features

1. Call Feature:

  • Allows issuer to redeem bond before maturity.

  • Usually done when interest rates fall — issuer wants to refinance at a lower rate.

  • To compensate investors, callable bonds often include a call premium (issuer pays slightly more than par when calling the bond).

  • Benefits issuer.

2. Put Feature:

  • Allows investor to force issuer to redeem bond early.

  • Usually used when interest rates rise — investor can reinvest in higher-yielding bonds.

  • Benefits investor.

3. Convertible Feature:

  • Allows bondholder to convert bond into shares of common stock.

  • If stock price rises, convertible bond value increases.

  • When bond price = conversion value → it is said to be at parity.

  • Benefit: Investor participates in potential stock appreciation.

4. Zero-Coupon Bonds:

  • Pay no periodic interest.

  • Issued at a deep discount and mature at par ($1,000).

  • The difference between purchase price and par = interest earned.

    • Example: XYZ Corp zero-coupon issued at 50 ($500).

      • Pays $1,000 at maturity (20 years) → $500 gain = interest.

      • YTM ≈ 3.53%

  • More volatile than other bonds with the same maturity (since all value is received at maturity).

  • Tax treatment:

    • Even though no interest is paid annually, investors must report imputed (phantom) interest each year.

    • The total discount is divided evenly over the bond’s life.

    • Example: $500 discount ÷ 10 years = $50/year → reported on Form 1099-INT.

    • This is called annual accretion of the discount.

⚖️ Summary Table

Yield Type / Definition / Key Points

  • Nominal Yield / Coupon rate fixed at issuance / % of par value

  • Current Yield / Annual interest ÷ Market price / Measures income return

  • Yield to Maturity (YTM) / Total return if held to maturity  / Includes gain/loss on price

  • Yield to Call (YTC) / Return if called early / Based on earliest call date

  • Basis Points / 1/100 of 1% / 100 bp = 1%

  • Call Feature / Issuer redeems early / Benefits issuer when rates fall

  • Put Feature / Investor redeems early / Benefits investor when rates rise

  • Convertible Feature / Exchange bond for stock / Tracks stock’s value  

  • Zero-Coupon Bond / Issued at discount, no interest / Phantom income taxed annually

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✺ Review questions ✺

  • The interest payments relative to the bond’s price/value.

  • Annual coupon ÷ market price.

  • YTM is higher than the coupon rate.

  • To refinance debt at a lower interest rate when market rates fall.

  • Allows investors to redeem early and reinvest when rates rise.

  • They are more volatile and investors must pay tax on phantom income each year.

  • 100 basis points